What's Next for the Economy?

Credit markets should improve by Thanksgiving. But we won't see GDP growth for a year.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

October 13, 2008

Editor's Note: This is an updated version of a Kiplinger Forecast that first appeared on Oct. 10, 2008. It includes new details and developments.

Uncle Sam's steps will help the economy and ease the mood of panic.

Moves by the Federal Reserve and Treasury Department to pump liquidity into credit markets and provide capital directly to banks will keep businesses' doors open and allow them to meet payrolls. They also will help set a floor under the housing market. But none of it will happen very soon, and that keeps many investors nervous.

Here's how we expect the situation to unfold. Within a few weeks, the Treasury will buy shares in banks, filling a gap left by scared investors. What will take a while is the establishment of ground rules: How much say the government will want in bank operations, how and when the equity investment will be paid back, and so on.

At the same time, Treasury is mapping out details of buying up banks' toxic debt, by getting it off their books -- and sequestering it for resale later. By Thanksgiving, it'll be clear how this program is going. Because the reverse auctions planned are complicated and uncertain, Treasury is accelerating Plan B -- buying banks' shares. The goal is the same: to pump so much money into the banking system that lending will revive. The U.S. effort is being helped by similar rescue plans mapped out by European nations, including the U.K. and Germany.

By year-end, credit markets should be functioning better. Commercial paper will be moving again. Long-term lending -- corporate bonds and so forth -- will start picking up. It will take many more months to return to normal, however. Wide interest rate spreads will linger well into 2009. Typically, the gap between T bill rates and three month Eurodollar loan rates, for example, is about half a percentage point. But right now, it’s 10 times that, which won’t be reversed quickly. And corporate bond issuances and bank lending won't return to more normal levels until confidence in the credit markets is restored.

The economy won't grow for about a year. While measures taken here by the Federal Reserve and Treasury Department and by central bankers abroad will avoid another Great Depression, all the king's horses and all the king's men can't reverse the business cycle. Recessions must run their courses.

Gross domestic product will shrink through at least the first half of 2009. In the second half, a weak recovery is the best to be hoped for. For the year, growth isn't likely to be much better than flat. We expect unemployment to climb to 7.5% or so next year and slightly higher in 2010: Joblessness typically continues to rise even after economic growth resumes, as businesses look first to expand current workers' hours and only after several months of growth feel secure enough to add to payrolls.

As for the stock market, the slide will end. What we have seen in recent weeks is a classic panic. It will end when everyone prone to panicking has done so. When the turn around comes, you don’t want to miss it. That’s why our consistent advice is to stay the course. If you have an investment plan in place appropriate to your age, income, retirement horizon and tolerance for risk, now’s not the time to change it.

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