Interim Assistant Secretary for Financial Stability Neel Kashkari discussed Wednesday morning the implementation of the Emergency Economic Stabilization Act (the $700bn financial rescue program) with the members of Women in Housing and Finance and the Exchequer Club of Washington. Kashkari said: While we have taken actions to stabilize the banking sector, supporting the non-banking market is also important to helping consumers, businesses and our economy get the credit they need. The consumer securitization market appears to be a promising opportunity. This would help bring down rates of auto loans, credit cards and student loans.

US investment bank Morgan Stanley said on Wednesday that a perfect consumer storm is in prospect to mid-2009; the downturn will be deep and a long period of convalescence will follow. Also on Wednesday, Germany’s economy minister, Michael Glos, said in a television interview that the 27 members of the European Union (EU) would be each asked to contribute 1% of their gross domestic product to a growth package stimulus that would be worth “about €130bn” overall. The commitment from Ireland would be about  €1.7bn.

New US housing starts in October, were reported on Wednesday to have fallen to the lowest level since 1959. The Commerce Department said that construction of new homes and apartments fell 4.5% in October, the fourth monthly decline in a row.

US consumer prices plunged 1% last month - - thee most since records began in 1947, after being unchanged in September. Excluding food and energy, so-called core prices unexpectedly dropped for the first time since 1982.

In Germany, which accounts for 30% of the output of the 15-member country Eurozone, draft German budget figures for 2009 show the federal and regional governments have allocated €4bn to cover the cost of the 15 growth-enhancing measures that were proposed two weeks ago - - less than 1% of GDP but the German government said that its commitment would include measures the government had already adopted, which it claims amount to €32bn over two years, or more than 1% of GDP. Support measures for the car and construction industries are also being considered. EU leaders will attend a summit meeting on December 11-12.

Morgan Stanley economist Richard Berner, says the evidence on the US downturn, is grim: He estimates that real spending contracted at a 3.3% annual rate in the summer quarter and will decline at a slightly less-intense 2.4% in the current quarter.  One has to go back to the spring of 1980 to find a deeper two-quarter drop.  This plunge has arrived with more downward momentum than expected even a few months ago.

Morgan Stanley says the current collapse in consumer spending likely will be the most severe and longest in the postwar period.  The investment bank says the intensity of the downdraft will abate in the first half of 2009 as lower energy quotes and fiscal stimulus mitigate the downturn.  Nonetheless, the estimated plunge in real consumption in the year ending Q2 09 of -1.6% would set a postwar record.  As important, investors should not count on a V-shaped rebound.  The recovery in consumer spending likely will be moderate as consumers embark on a long period of rebuilding thrift. 

Why so dire?  Five forces are promoting retrenchment.   Berner says consumers might have been able to weather some of them, but collectively, they add up to a perfect storm.  First, employment and income are sinking as the economy weakens.  The loss of 1.2 million jobs since the beginning of the year already has drained about $70 billion annualized (0.6%) from pretax income, and further job cuts are likely.  Indeed, the pace of job loss has accelerated sharply since midyear, with the 77,000 average monthly loss in the first six months more than doubling in the June-October period to 180,000 per month.  With jobless claims soaring past the 500,000 mark for the first time since the short-lived spike after 9/11, the pace seems unlikely to abate soon.

Second and third, equity and home prices are plunging, promoting a record loss in household wealth that is affecting every rung of the income and wealth ladder. The free fall in global equity prices since the beginning of the year – 46% measured by the MSCI all-country composite – has slashed the value of US equity wealth by about $7 trillion.  Morgan Stanley estimates that the drop in home prices so far – just 6.5% from the peak in the spring of 2007 as measured by the FHFA purchase-only price index – will have sliced $1.5 trillion from the value of household real estate by the end of this year.  That decline may understate the loss in housing wealth, because the FHFA measure excludes properties financed with jumbo and subprime mortgages, both of which have declined by more in value.  Taken together, such wealth losses probably will prompt consumers to cut spending by about one percentage point this year and more in coming years. 

Fourth, housing foreclosures are rising, threatening to intensify the declines in home prices and the loss in household wealth, and promoting severe disruption among many households.  The national foreclosure start rate jumped to 2.75% of all mortgage loans in the second quarter, resulting in about 1.5 million foreclosure starts in inventory, and Federal Reserve economists project a further rise of about 1 million foreclosure starts before leveling off.  Not all those starts will result in foreclosures, but unless foreclosure mitigation increases under programs such as the Hope for Homeowners and Hope Now Alliance, this distress will likely weigh on housing values and consumer spending.

Perhaps most immediately important, the credit crunch has raised the cost and reduced the availability of credit.  Richard Berner says that credit restraint has increased episodically since the subprime meltdown in February 2007.  But the systemic shock from the sudden demise of Lehman Brothers in mid-September created dislocations in funding markets and sharp declines in the values of collateral, taking lender caution to new record levels.  That caution has spread from mortgage debt to consumer lending markets, freezing the securitization process for consumer loans.  According to the Fed’s Senior Loan Officer Survey of bank lending practices, banks are less willing today to extend consumer installment credit than at any time since 1980 – when the Carter Administration briefly imposed credit controls – and the decline in such willingness over the year ended in November is the sharpest of any except in that period. 

It’s hardly surprising that this deeper credit restraint has recently promoted sharp declines in outlays on credit-sensitive, big-ticket items like vehicles, furniture and household appliances and other durables.  Indeed, such restraint has been a key ingredient in our perfect storm thesis for the past year.  Morgan Stanley says a year ago, they were hopeful that policy actions would help avoid a full-blown credit crunch.  "Now that we are in the midst of one we need to guess its impact and understand what might end it.  A recent study by Macroeconomic Advisers sheds light on the impact: Controlling for all the headwinds mentioned above, they find that tighter lending standards alone will cut consumer spending by about 1.5% in the current quarter, adding to the drag from other factors.  Assuming that the downtrend in willingness to lend has peaked, the drag on spending may have peaked in this quarter, but lender caution likely will persist as the recession deepens and credit quality deteriorates," Morgan Stanley says.

Plummeting energy quotes, additional fiscal stimulus and the eventual benefits of monetary ease likely will avert a deeper downturn. Most immediately, Morgan Stanley estimates that if sustained the plunge in gasoline prices alone – from over $4/gallon this summer to today’s $2.45 – will represent the functional equivalent of a $225 billion tax cut for consumers, adding about 2.1% points to disposable income.  A lame-duck fiscal stimulus package seems to be on hold at the moment, but more bad economic news may change the picture.  And a major stimulus initiative seems inevitable shortly after the Obama Administration takes office.  Done right, and coupled with other policies to mitigate the credit crunch and foreclosures, such initiatives should begin to limit the downturn and promote a modest recovery beginning in 2010. 

The eventual recovery in consumer spending likely will be moderate. Richard Berner says this recession is more than a cyclical event; "we think it will trigger a sea change in consumer spending behavior as consumers now embark on a long period of rebuilding thrift.  On the asset side, there is further downside risk to both home and equity prices, and even when they trough, a rapid rebound is unlikely.  On the liability side, it will take time to deleverage and realign debt service with income.  If we’re right that markets recover slowly from these shocks, balance sheet repair will require more saving out of current income and involve real consumer spending growth of no more than 2-2.5% over the next several years, compared with 3.5% over the decade ended in 2007.  The golden age of spending for the American consumer has ended, and a new age of thrift likely has begun."

Corporate America also faces a slow pace of improvement for both assets and liabilities.  Leveraged lenders must rebuild their balance sheets with new capital, continue to write off and provision for a significant volume of soured loans, and repay the capital on loan from the Treasury through the TARP ($700bn financial rescue program).  Moreover, regulators will seek to reinforce lender caution and safety by requiring higher minimum capital, thus limiting leverage and reducing credit growth and ROEs for Corporate America. In all, these forces should promote a sober but more sustainable spending backdrop.

For investors, this dismal setting is not an inspiration to embrace battered risky asset markets.  Although a lot of bad news is in the price of risky assets, a severe downturn and long period of convalescence may not be, says Morgan Stanley. "In particular, we doubt that a long period of convalescence and slow growth is in the stock prices of consumer companies." 

The environment is still a minefield of risks.  Richard Berner says the near-term risk is that adverse feedback loops continue to spiral into a more severe downturn, with economic weakness escalating into a deflation scare.  In our view, policymakers are prepared to take additional and unprecedented policy actions to avert that outcome.  The longer-term market risk is that an extended period of convalescence will lead to an extended period of underperformance for risky assets.