NORTHERN TRUST GLOBAL ECONOMIC RESEARCH

U.S. Economic and Interest Rate Outlook

The Shoals of Depression Have Been Avoided, but the Economy

Still Faces Strong Headwinds
September 2009

Paul L. Kasriel, Chief Economist

PH: 312.444.4145
plk1@ntrs.com
© 2006 Northern Trust Corporation northerntrust.com
 We have just weathered the longest (19 months?) and deepest
recession in the post-WWII era.

Real Gr oss Domestic Pr oduct

% Change - Year to Year SAAR, Bil. Chn. 2005$

16 16

12 12

8 8

4 4

0 0

-4 -4
50 55 60 65 70 75 80 85 90 95 00 05
Sour ce: Bur eau of Economic Analysis /Haver Analytics

2 Northern Trust Global Economic Research

 In August, the ISM-Mfg. Composite Index popped above 50 for the
first time since January 2008.

ISM Manufactur ing: PMI Composite Index

SA, 50+=Incr easing

56 56

52 52

48 48

44 44

40 40

36 36

32 32
SEP OCT NOV DEC JAN FEB MAR APR MAY JUN JUL AUG
09
Sour ce: Institute for Supply Management /Haver Analytics

3 Northern Trust Global Economic Research

 The behavior of the ISM-Mfg. Index suggests that the recession
ended in July 2009.

ISM Manufactur ing: PMI Composite Index

SA, 50+=Incr easing

80 80

70 70

60 60

50 50

40 40

30 30

20 20
50 55 60 65 70 75 80 85 90 95 00 05
Sour ce: Institute for Supply Management /Haver Analytics

4 Northern Trust Global Economic Research

 It is not that any one sector is soaring …

…rather a number of sectors have either stopped

descending or are descending at a much slower
rate.
 Thanks to the sharp decline in home prices and the low level of
mortgage rates, house purchases are now much more affordable.

Composite Housing Affor dability Index

Median Inc=Qualifying Inc=100

180 180

160 160

140 140

120 120

100 100

80 80

60 60
75 80 85 90 95 00 05
Sour ce: National Association of Realtor s /Haver Analytics

6 Northern Trust Global Economic Research

 High housing affordability plus the $8K first-time-homebuyer tax credit have
resulted in four consecutive monthly increases in home sales.

Home Sales: Sum of New and Existing

SAAR, Thous

9000 9000

8250 8250

7500 7500

6750 6750

6000 6000

5250 5250

4500 4500
02 03 04 05 06 07 08 09
Sour ce: Haver Analytics

7 Northern Trust Global Economic Research

 The sharp decline in the inventory of new homes has led to five
consecutive increases in starts of new single-family homes.

Housing Star ts: 1 Unit

SAAR, Thous. Units

New 1-Family Houses For Sale: United States

SA, Thous
2000 600

1600 525

1200 450

800 375

400 300

0 225
02 03 04 05 06 07 08 09
Sour ce: Census Bur eau /Haver Analytics

8 Northern Trust Global Economic Research

 Thus, after its steep slide starting in 2006, expenditures related to
residential construction appear to have bottomed.

Pr ivate Constr uction: Residential

SAAR, Mil. $

700000 700000

600000 600000

500000 500000

400000 400000

300000 300000

200000 200000
02 03 04 05 06 07 08 09
Sour ce: Census Bur eau /Haver Analytics

9 Northern Trust Global Economic Research

 The tax cuts of the fiscal stimulus program plus unemployment insurance have helped
stabilize disposable personal income, which, in turn, has helped stabilize consumer
spending.

Real Per sonal Consumption Expenditur es ex Motor Vehicles

SAAR, Tr il. Chn. 2005$

Real Disposable Per sonal Income

SAAR, Bil. Chn. 2005$
9. 0 10500

10250
8. 8

10000
8. 6

9750

8. 4
9500

8. 2
9250

8. 0 9000
05 06 07 08 09
Sour ce: Haver Analytics

10 Northern Trust Global Economic Research

 Car and truck sales appeared to have bottomed even before “cash-for-
clunkers.” There is natural replacement demand given that some of us are
still driving 1995 Subarus!

Total Light Vehicle Retail Sales {Impor ted+Domestic}

SAAR, Mil. Units

22. 5 22. 5

20. 0 20. 0

17. 5 17. 5

15. 0 15. 0

12. 5 12. 5

10. 0 10. 0

7. 5 7. 5
06 07 08 09
Sour ce: Autodata Cor por ation /Haver Analytics

11 Northern Trust Global Economic Research

 Some of those drill presses, computers, and 737s need replacing, too.

Manufactur er s' Shipments: Nondefense Capital Goods

SA, Mil. $

70000 70000

67500 67500

65000 65000

62500 62500

60000 60000

57500 57500

55000 55000
06 07 08 09
Sour ce: Census Bur eau /Haver Analytics

12 Northern Trust Global Economic Research

 Economic activity is improving in the developed economies …

Eur o Ar ea16: Gr oss Domestic Pr oduct

% Change - Annual Rate SA/WDA, Mil. Chn. 00. Eur os

Japan: Gr oss Domestic Pr oduct

% Change - Annual Rate SAAR, Bil. Chn. 2000. Yen
8 8

4 4

0 0

-4 -4

-8 -8

-12 -12

-16 -16
06 07 08 09
Sour ces: Eur ostat, CAO /Haver

13 Northern Trust Global Economic Research

 … as well as in China …

China: Real GDP: Year -to-Year Per cent Change

12 12

11 11

10 10

9 9

8 8

7 7

6 6
06 07 08 09
Sour ce: China National Bur eau of Statistics /Haver Analytics

14 Northern Trust Global Economic Research

 … other developing economies.

Kor ea: Gr oss Domestic Pr oduct

% Change - Annual Rate SA, Bil. Ch. 2005. Won

Singapor e: GDP at 2000 Pr ices

SAAR, Q- Q % Change
22. 5 22. 5

15. 0 15. 0

7. 5 7. 5

0. 0 0. 0

-7. 5 -7. 5

-15. 0 -15. 0

-22. 5 -22. 5
06 07 08 09
Sour ces: Bank of Kor ea, Depar tment of Statistics/Haver Analytics

15 Northern Trust Global Economic Research

 The economic recovery underway in the rest of the world is boosting
U.S. exports.

Expor ts, f. a. s.

SA, Mil. Chn. 2005$

105000 105000

100000 100000

95000 95000

90000 90000

85000 85000

80000 80000

75000 75000

07 08 09
Sour ce: Bur eau of the Census /Haver Analytics

16 Northern Trust Global Economic Research

 State & local government infrastructure spending in Q2 grew at its fastest rate
since 2001 due to the “Build America Bonds” program authorized by the
fiscal stimulus program.

Real State & Local Govt Gr oss Investment

% Change - Annual Rate SAAR, Bil. Chn. 2005$

30 30

20 20

10 10

0 0

-10 -10

-20 -20

-30 -30
01 02 03 04 05 06 07 08 09
Sour ce: Bur eau of Economic Analysis /Haver Analytics

17 Northern Trust Global Economic Research

 Speaking of the stimulus program, for the most part, the federal
spending portion of it has yet to kick in.

Real Feder al Nondefense Gr oss Investment

% Change - Annual Rate SAAR, Bil. Chn. 2005$

60 60

40 40

20 20

0 0

-20 -20

-40 -40
08 09
Sour ce: Bur eau of Economic Analysis /Haver Analytics

18 Northern Trust Global Economic Research

 After the largest inventory liquidation in the post-WWII era, some businesses
will have to begin restocking because their shelves are bare.

Change in Business Inventor ies as % of Final Sales of Domestic Pr oduct

SAAR, Chn. 2005$

2. 25 2. 25

1. 50 1. 50

0. 75 0. 75

0. 00 0. 00

-0. 75 -0. 75

-1. 50 -1. 50
50 55 60 65 70 75 80 85 90 95 00 05
Sour ce: Haver Analytics

19 Northern Trust Global Economic Research

 Although job growth and a drop in the unemployment rate have yet to
occur, both of these improving labor-market indicators tend to lag in
economic recoveries.

All Employees: Total Nonfar m

% Change - Per iod to Per iod SA, Thous

Civilian Unemployment Rate: 16 yr +

SA, %
1. 6 12

1. 2
10

0. 8
8

0. 4

6
0. 0

4
-0. 4

-0. 8 2
65 70 75 80 85 90 95 00 05
Sour ce: Bur eau of Labor Statistics /Haver Analytics

20 Northern Trust Global Economic Research

 But the level of first-time unemployment insurance claims is falling,
which typically happens just before or at the onset of recoveries.

Initial Claims for Unemployment Insur ance, State Pr ogr ams, Wkly Avg

SA, Thous

700 700

600 600

500 500

400 400

300 300

200 200

100 100
70 75 80 85 90 95 00 05
Sour ce: Depar tment of Labor /Haver Analytics

21 Northern Trust Global Economic Research

 If there is one sector that is not improving, it is commercial real estate.

Private Construction: Nonresidential

%Change - Year to Year SAAR, Mil.$

„A lagging sector.
40 40
„ High and rising unemployment will
keep office vacancy rates rising. 30 30

„ Mall vacancy rates will remain high

as retailing is years away from 20 20

returning to its recent boom era.

10 10
„ Hotel vacancy rates will remain high
as discretionary travel will be slow to
0 0
strengthen.
-10 -10

-20 -20
65 70 75 80 85 90 95 00 05
Source: Census Bureau/Haver Analytics

22 Northern Trust Global Economic Research

Financial market conditions are improving
 After Lehman collapsed, the interbank loan market froze up. This market now
is thawing as evidenced by the decline in Libor interest rates and the decline
in discount-window borrowing from the Fed.

Inter est Rate Spr ead: 3-Month Libor minus Fed Discount Rate
per centage points

Reser ve Bank Cr edit: Pr imar y Cr edit to Depositor y Institutions

Avg, Mil. $
3. 00 120000

100000
2. 25

80000
1. 50

60000

0. 75
40000

0. 00
20000

-0. 75 0

08 09
Sour ce: Haver Analytics

24 Northern Trust Global Economic Research

 After Lehman failed, the bond market was pricing in a rerun of the early
1930s. Risk appetites have been whetted now that the worst case has not
occurred.

Inter est Rate Spr ead: High Yield Cor por ate minus Tr easur y 10-Yr .
per centage points

Mer r ill Lynch High Yield Cor por ate Master II: Effective Yield
%
24 24

20
20

16
16

12

12
8

8
4

0 4
06 07 08 09
Sour ce: Haver Analytics

25 Northern Trust Global Economic Research

 The S&P 500 was up nearly 50% from its early March low by Labor Day.

Standar d & Poor 's 500 Stock Pr ice Index

EOP, 1941-43=10

1600 1600

1400 1400

1200 1200

1000 1000

800 800

600 600
06 07 08 09
Sour ce: Wall Str eet Jour nal /Haver Analytics

26 Northern Trust Global Economic Research

The economy still faces strong headwinds
 Commercial banks are experiencing extremely high loan charge-off
and delinquency rates.

Loan Char ge-Off Rate: All Insur ed Commer cial Banks

SAAR,%

Loan Delinquency Rate: All Insur ed Commer cial Banks

SA,%
8 8

6 6

4 4

2 2

0 0
85 90 95 00 05
Sour ce: Feder al Reser ve Boar d /Haver Analytics

28 Northern Trust Global Economic Research

 As a result, there has been an unprecedented decline in net lending
by the private financial system.

Pr ivate Financial System: Cr edit Mar ket Funds Advanced

SAAR, Bil. $

6000 6000

4000 4000

2000 2000

0 0

-2000 -2000
55 60 65 70 75 80 85 90 95 00 05
Sour ce: Haver Analytics

29 Northern Trust Global Economic Research

 Financial institutions have acquired much-
needed capital through the TARP program
and new equity issuance in the market. But
with a wave of commercial mortgage
defaults expected, some institutions could
become undercapitalized again.

Until financial institutions are confident of their

longer-run capital adequacy, they will be unable
and/or reluctant to create new credit, which will
restrain the pace of the economic recovery.
It will take households some time to recover
from their “overindulgence” in the past
expansion.
 Total household expenditures reached record highs relative to after-
tax income in the past ten years.

Sum of Consumer and Residential Investment Expenditur es / HH After -Tax Income

105. 0 105. 0

102. 5 102. 5

100. 0 100. 0

97. 5 97. 5

95. 0 95. 0

92. 5 92. 5

90. 0 90. 0
50 55 60 65 70 75 80 85 90 95 00 05
Sour ce: Haver Analytics

32 Northern Trust Global Economic Research

 In order to fund their increased spending, households stepped up their
borrowing, largely against the equity in their houses, to record levels relative
to their after-tax incomes.

Households: Bor r owing as a % of After -Tax Income

15. 0 15. 0

12. 5 12. 5

10. 0 10. 0

7. 5 7. 5

5. 0 5. 0

2. 5 2. 5

0. 0 0. 0
55 60 65 70 75 80 85 90 95 00 05
Sour ce: Haver Analytics

33 Northern Trust Global Economic Research

 The record increase in household debt in combination with massive declines
in the market value of their assets has resulted is a sharp loss in net worth, or
household wealth.

Households & Nonpr ofit Or g: Net Wor th as a % of Disposable Per sonal Income

640 640

600 600

560 560

520 520

480 480

440 440

400 400
55 60 65 70 75 80 85 90 95 00 05

34 Northern Trust Global Economic Research

 Households are likely to rebuild their wealth through the purchases of stocks
and bonds rather than the purchases of McMansions, SUVs and plasma TVs.
All else the same, this would impart downward pressure on interest rates.

Households: Net Acquisition of Financial Assets

SAAR, Bil. $

Households & Nonpr ofit Or gs: Capital Expenditur es

SAAR, Bil. $
2000 2000

1600 1600

1200 1200

800 800

400 400

0 0
55 60 65 70 75 80 85 90 95 00 05
Sour ce: Feder al Reser ve Boar d /Haver Analytics

35 Northern Trust Global Economic Research

Is the federal deficit a headwind?
 Not right now. Although Treasury borrowing has soared in recent
quarters, the pace of nonfederal borrowing has slowed sharply.

Feder al Gover nment: Liabilities: Cr edit Mar ket Instr uments

4-qtr MovingAver age SAAR, Bil$

Nonfeder al Sector s: Liabilities: Cr edit Mar ket Instr uments

4-qtr MovingAver age SAAR, Bil. $
2500 2500

2000 2000

1500 1500

1000 1000

500 500

0 0

-500 -500
55 60 65 70 75 80 85 90 95 00 05
Sour ces: Feder al Reser ve Boar d, Haver Analytics

37 Northern Trust Global Economic Research

 Thus, the pace of total nonfinancial sector borrowing has slowed,
which has helped keep Treasury yields at relatively low levels.

Domestic Nonfinancial Sector s: Liabs: Cr edit Mkt Instr uments

4- qtr MovingAver age SAAR, Bil. $

Long-Ter m Tr easur y Composite, Over 10 Year s

% p. a.
3000 15. 0

2500 12. 5

2000 10. 0

1500 7. 5

1000 5. 0

500 2. 5

0 0. 0
55 60 65 70 75 80 85 90 95 00 05
Sour ces: Feder al Reser ve Boar d, U. S. Tr easur y /Haver Analytics

38 Northern Trust Global Economic Research

 But with federal budget deficits projected to run at rates near 4% of GDP well into the
economic recovery, federal spending could “crowd out” business investment, which
would lower future potential economic growth.

Feder al Sur plus/Deficit [-]: Per cent of GDP

Fiscal Year , %

8 8

4 4

0 0

-4 -4

-8 -8

-12 -12
50 55 60 65 70 75 80 85 90 95 00 05 10 15 20
Sour ce: Office of Management and Budget /Haver Analytics

39 Northern Trust Global Economic Research

Will the headwinds prevail, pushing the
economy back into recession?
 Not likely. Over 50 years of history suggests that the economy does
not enter a recession unless the Fed pushes it into one.

Feder al Funds [effective] Rate

% p. a.

20 20

16 16

12 12

8 8

4 4

0 0
55 60 65 70 75 80 85 90 95 00 05
Sour ce: Feder al Reser ve Boar d /Haver Analytics

41 Northern Trust Global Economic Research

What about inflation? Won’t all the credit
the Fed has created in recent years
guarantee rapid inflation?
 Fed credit has soared from $877 billion at the end of 2007 to over $2
trillion at the end of August 2009.

Reser ve Bank Cr edit Outstanding

EOP, Mil. $

2400000 2400000

2000000 2000000

1600000 1600000

1200000 1200000

800000 800000

400000 400000

0 0
90 95 00 05
Sour ce: Feder al Reser ve Boar d /Haver Analytics

43 Northern Trust Global Economic Research

 But the bulk of this Fed credit creation has ended up as currency sitting in
safe deposit boxes and excess, or idle, cash sitting on the books of banks.

Reser ve Bank Cr edit Outstanding

EOP, Tr il. $

Sum of Excess Reser ves and Cur r ency in Cir culation

Tr il. $
2. 4 2. 4

2. 0 2. 0

1. 6 1. 6

1. 2 1. 2

0. 8 0. 8

0. 4 0. 4

0. 0 0. 0
90 95 00 05
Sour ce: Haver Analytics

44 Northern Trust Global Economic Research

 Although growth in the broad measure of money supply skyrocketed right
after the Lehman failure, it has fallen back to Earth in recent months.

Money Stock: M2
6-month %Change-ann SA, Bil.$

15.0 15.0

12.5 12.5

10.0 10.0

7.5 7.5

5.0 5.0

2.5 2.5

0.0 0.0
96 97 98 99 00 01 02 03 04 05 06 07 08 09
Source: Federal Reserve Board /Haver Analytics

45 Northern Trust Global Economic Research

 To summarize:

„ The recovery has commenced.

„ Balance sheet repair by financial institutions and households will restrain the
pace of the recovery through 2010.
„ Because the recovery will be muted initially, the unemployment rate is likely to
continue rising through the first half of 2010, perhaps peaking out at a level over
10-1/2%.
„ Thesharp increase in Fed credit is not currently inflationary, but has the
potential to be if the Fed does not neutralize this credit at the appropriate time.
„ The
earliest the Fed is likely to begin “neutralizing” the credit it has created is
midyear 2010 and then, only tentatively.

46 Northern Trust Global Economic Research

 Selected Business Indicators

Table 1 US GDP, Inflation, and Unemployment Rate

2008 2009 2010 Q4 to Q4 Change Annual Change

08:3a 08:4a 09:1a 09:2a 09:3f 09:4f 10:1f 10:2f 10:3f 10:4f 2008a 2009f 2010f 2008a 2009f 2010f
REAL GROSS DOMESTIC PRODUCT -2.7 -5.4 -6.4 -1.0 2.5 1.9 1.6 2.3 2.5 3.2 -1.9 -0.8 2.4 0.4 -2.7 1.9
(% change from prior quarter )

CONSUMPTION EXPENDITURES -3.5 -3.1 0.6 -1.0 2.0 1.5 1.7 2.0 2.0 2.3 -1.8 0.8 2.0 -0.2 -0.7 1.7
BUSINESS INVESTMENT -6.1 -19.5 -39.2 -10.9 -13.2 -5.4 -3.2 -0.8 0.2 2.8 -6.0 -18.3 -0.3 1.6 -19.3 -4.2
RESIDENTIAL INVESTMENT -15.9 -23.2 -38.2 -22.8 0.0 1.0 1.5 2.5 4.0 5.0 -21.0 -16.7 3.2 -22.9 -22.2 0.2
CHANGE IN INVENTORIES ('00 dlrs, bill) -29.7 -37.4 -113.9 -159.2 -150.9 -120.9 -115.9 -105.9 -100.9 -85.9 -25.9* -136.2* -102.2*

GOVERNMENT 4.8 1.2 -2.6 6.4 2.4 1.8 1.6 1.3 2.1 1.8 3.1 1.9 1.7 3.1 1.9 2.0
NET EXPORTS ('00 dlrs, bill.) -479.2 -470.9 -386.5 -331.8 -295.4 -293.0 -285.4 -274.3 -262.9 -253.5 -494.3* -326.7* -269.1*
FINAL SALES -2.9 -4.7 -4.1 -0.1 1.7 0.9 1.4 2.0 2.3 2.7 -1.4 -0.3 2.1 0.8 -1.8 1.6

NOMINAL GROSS DOMESTIC PRODUCT 1.4 -5.4 -4.6 -1.0 5.2 3.9 3.7 3.7 4.6 4.8 0.1 0.8 4.8 2.6 -1.1 4.1

GDP DEFLATOR - IMPLICIT (% change) 4.1 0.0 1.9 1.1 2.6 2.0 2.1 2.3 2.3 2.9 2.0 1.6 2.4 2.1 1.6 2.1
CPI (% Change, 1982-84 = 100) 6.2 -8.3 -2.4 1.3 2.8 2.2 2.3 2.5 2.5 3.1 1.5 1.0 2.6 3.8 -0.5 2.4
CIVILIAN UNEMPLOYMENT RATE (avg.) 6.1 6.9 8.1 9.3 9.7 10.1 10.4 10.7 10.7 10.5 5.8* 9.3* 10.6*

a=actual
f=forecast
*=annual average

47 Northern Trust Global Economic Research

 Outlook for Interest Rates

TABLE 2 Outlook for Interest Rates

Quarterly Average Annual Average
SPECIFIC INTEREST RATES 08:3a 08:4a 09:1a 09:2a 09:3f 09:4f 10:1f 10:2f 10:3f 10:4f 2008a 2009f 2010f

Federal Funds 1.94 0.51 0.18 0.18 0.16 0.20 0.25 0.25 0.70 1.20 1.93 0.18 0.60

2-yr. Treasury Note 2.36 1.21 0.91 1.01 1.05 1.00 1.05 1.20 1.50 1.85 2.00 0.99 1.40
10-yr. Treasury Note 3.86 3.25 2.74 3.31 3.55 3.60 3.70 3.85 4.00 4.15 3.67 3.30 3.93

a = actual
f = forecast

48 Northern Trust Global Economic Research