This is not a fun time to be forecasting the outlook for the economy. Not only are the prospects dim, but uncertainty is at an all-time high. One thing is certainly clear: the U.S. economy slowed in 2008. The most recent GDP release showed that economic activity in the third quarter declined 0.3 percent, the worst performance since a 1.4 percent decline in the third quarter of 2001 (thanks to the Sept. 11 terrorist attacks).

Add the turmoil in the financial markets and the current freeze in credit to this weak economic scenario, and the outlook is clearly grim. In fact, economists generally expect economic activity to slow even further in the fourth quarter and most predict declines will continue into early 2009. There's no longer a question of whether the economy will fall into a recession, it's more a question of when the recession began, when it will end and how bad it will be. For 2008 as a whole, economic growth is likely to average just 1.6 percent, followed by a very sluggish 1.0 percent expansion in 2009.

Consumers pull back

Consumer spending was a key culprit in GDP's third-quarter decline: It plunged at an annual rate of 3.1 percent from the previous quarter. The decline was the sharpest since an 8.6 percent drop in the second quarter of 1980 and is critical because consumers have accounted for as much as 70 percent of economic activity in recent years. This year, however, consumers are dealing with affronts on many different sides. For example, payroll employment has declined for nine straight months. A total of 760,000 jobs have been lost in the first nine months of this year, and the unemployment rate has risen from a low of just 4.4 percent in March 2007 to 6.1 percent in September 2008 an increase of 1.7 percentage points over a short 18 months. With job cuts come declines in aggregate income, and that has a direct impact on bottom-line spending.

But that's not been the only damper on consumer spending. Consumers have seen their accumulated wealth disappear at a frightening rate over the past few years. The S&P/Case-Shiller Home Price Index measures repeat sales and refinancing for the same homes and this index shows that house prices (nationally) reached a peak in July 2006 and lost a full 20 percent of their value by August 2008 (the most recent information). Similarly the stock market's recent declines have wiped out a considerable amount of consumers' paper wealth. The S&P 500 Stock Price Index, for example, declined 39 percent over the year from its peak on Oct. 9, 2007 (at 1,565) through the end of October 2008 (at 954). Although declines in wealth have a less direct impact on spending than declines in income, they do have a measurable effect and consumers have pulled back as a result.

Inflation outlook to improve

The final assault on the consumer has come from rising inflation, which took a bite out of spending power during much of 2008. In July, the consumer price index rose 5.6 percent, the highest year-over-year percent change since January 1991. Higher fuel costs were largely to blame the energy component of the consumer price index in the first eight months of 2008 grew 21 percent compared to a year earlier. The price of oil climbed above $140 per barrel in July and the national price of gas exceeded $4 per gallon.

In 2009, only the inflation outlook is expected to improve relative to 2008. In the third quarter of 2008, the demand for gasoline slipped in response to both high prices and the soft economy. By October, the price per barrel of oil had fallen below $70 per barrel, and the national price of gasoline had retreated to less than $3.00 per gallon. With energy prices down, price inflation should remain more subdued in 2009.

Another reason for the more moderate inflation of 2009, however, will be that consumer demand remains soft as the economy makes little progress through the first half of the year. The labor market will remain weak, the stock market will make only halting progress and house prices are not likely to turn around before mid-year and possibly not until late in the year, given continued foreclosures and the elevated inventory of unsold homes.

Looking ahead

But the economy will turn more positive in the latter half of 2009. Congress and the Federal Reserve have initiated a number of stimulus measures that, while taking time, will begin to be felt by the middle of the year. The Federal Reserve has lowered interest rates to 1.0 percent (like they did following Sept. 11), which should stimulate economic activity once the credit markets begin to thaw. That thaw should occur in early 2009 thanks to the Congress' and the Fed's efforts to shore up bank liquidity and build confidence in the banking system. So, by the second half of 2009, GDP growth could reach 2 to 3 percent almost back to the economy's long-term growth potential. Although it will be a long ride getting there, the path should be much smoother by this time next year.

Chart 1:  This index shows that house prices (nationally) reached a peak in July 2006 and lost a full 20 percent of their value by August 2008.

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