On Track for Subdued Recovery

The government’s second estimate of economic growth for the third quarter provides a reminder that economic recovery
will be fragile for some time. Economic growth was slower than previously believed: Real (inflation adjusted) gross
domestic product (GDP) was revised downward to 2.8 percent (annualized rate) from 3.5 percent originally reported.
The revision showed that economic growth relied more on fiscal stimulus and less on the activities of the private sector.
Real (inflation adjusted) government spending rose 0.8 percentage points more than initially reported, largely through a
bigger increase in state and local construction outlays. The stronger government spending growth was outweighed by
downward revisions in the other components of GDP. Notably, real consumer spending growth was marked down by half
a percentage point to an annualized rate of 2.9 percent. Of that gain, nearly one percentage point was likely boosted by
the “cash-for-clunkers” program. Residential investment growth also was weaker than first reported but still contributed
about 0.5 percentage points to overall GDP growth. On the nonresidential investment side, investment in structures
dropped more sharply while investment in equipment and software increased more than originally reported.
The contribution from the private sector was heavily influenced by government incentive programs – which helped spur
the auto and the housing industries – as well as from slowing inventory liquidations. The fact that the boost to economic
growth came largely from the government and the inventory cycle is a source of some concern. On current assumptions,
the impact of fiscal stimulus will wane by mid-2010 and the stimulus will turn into a drag to growth in the second half of the
year. A slower pace of de-stocking will likely continue through the middle of next year, providing support to economic
growth. After that, as production and demand are more closely aligned, modest increases in inventories should resume
and no longer add significantly to growth. Thus, if private final demand (consumer spending, investment, and exports) do
not pick up strongly enough to replace the drag from the fading stimulus, the durability of the recovery could be in
question. A sustained recovery hinges on other sources of growth beside the temporary inventory swing and fiscal
stimulus.
The revised GDP has not significantly changed our near-term outlook. We expect economic growth to accelerate to 3.1
percent for the current quarter, supported by sharply slowing inventory liquidations and the fiscal stimulus. Wholesale
inventories rose in October, marking the first gain since August 2008. Real change in business inventories contributed
0.9 percentage points to economic growth in the third quarter. Its contribution will likely be substantially more in the
current quarter, supporting our expectations of a pickup in real GDP growth.
Our base forecast shows modest economic growth through most of 2010. Growth should pick up late next year due to
private-sector final demand strengthening – as we believe that job creation will likely be entrenched by then, boosting
incomes and confidence. In addition, household balance sheets will likely improve materially as the saving rate rises amid
continued improving equity prices. Consumers may be less cautious about spending, especially if financing terms ease.
We also expect that residential investment will add to growth all of next year, as homebuilding activity continues its
modest recovery. Nonresidential investment should no longer be a drag to economic growth in 2010. Nonresidential
investment in equipment and software should grow significantly, albeit from depressed levels, as businesses continue to
replace depreciated equipment. While we expect nonresidential investment in structures to decline all through next year
as commercial real estate will continue to face tight financing conditions, rising vacancy rates, and declining prices, the
sector is relatively small relative to the size of GDP, limiting the drag to growth. We do not expect net exports to be a
source of economic growth next year as demand for imports will be strong in a recovery. However, the decline in the
dollar will benefit U.S. exports, keeping the drag to economic growth from trade at a moderate level.
Developments in the labor market are critical for this outlook. If job creation is not materially improved by the end of 2010
as we expect, economic growth in 2010 will be much weaker than the 3 percent pace we are projecting. One downside
risk to growth is continued tight financing conditions, especially to consumers and small businesses. Other downside

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risks include accelerated and/or prolonged declines in home prices, which, if significant enough, could cause the economy
to slip back into recession.
The outlook may be brighter than we anticipate. Consumers may be more resilient, perhaps because asset prices (both
from equity and homes) continue to surprise on the upside and/or if the labor market improves substantially sooner than
expected. For example, if home prices have already troughed, we could see economic growth as much as one
percentage point higher in 2010 than our base outlook.
News from the November employment report was encouraging in many respects. First, payroll losses shrank to 11,000
on a seasonally adjusted basis from a drop of 111,000 in October. This marks the smallest loss since the recession
began. Second, job losses in the prior two months were revised lower by a total of 159,000. Third, the unemployment
rate, calculated from a separate survey of households, edged down 0.2 percentage points to 10.0 percent – the first drop
since July.
Leading indicators of the labor market indicate material improvement in market conditions. First, the length of the
workweek increased to 33.2 hours from a record low of 33.0 hours in October. For the manufacturing sector, the average
workweek has increased by one hour since May to 40.4 hours in November. The hope is that since businesses have
started to add hours to existing workers, they will need to start hiring new workers in the near future.
Second, temp employment – a harbinger of permanent hiring – has posted accelerating gains during the past four
months. These developments suggest that businesses have become more optimistic toward future demand and therefore
are less skittish about hiring. Third, the number of people working part-time for economic reasons declined during the
month. While the number is still about 25 percent higher than the level a year ago, the increase was much more
moderate than the 80 percent year-over-year increase seen earlier in the year.

Other reports also offered evidence of a stabilizing labor market. Challenger, Gray & Christmas reported that the number
of layoff announcements in November dropped to less than one-third of the level a year ago. A separate report on weekly
initial unemployment claims showed that the number of new jobless claims has fallen below 475,000 during the past three
weeks, putting the four-week moving average reading at the lowest level since September 2008. Claims have declined by
about 30 percent since their peak at the end of March.

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Some aspects of the labor market remain grim, however. Most importantly, people tend to stay jobless longer. The share
of those suffering long-term unemployment (longer than six months) rose to a record high since record keeping began in
1948. The number of workers who still want a job but have been unemployed for 27 weeks or longer as a share of
unemployed persons was 38.3 percent in November.
Overall, the significantly smaller job losses do not mean that
the economy will start adding jobs appreciably right away.
While the job market is not showing signs of deterioration, a
sustained increase in employment will likely be gradual.
Employment will likely move sideways or tick up modestly for
some time before job creation will be strong enough to bring
down the unemployment rate. Given the likely increases in
the number of people looking for jobs in the coming year, it
will probably take about 140,000 sustained job gains per
month to push the unemployment rate lower, according to the
consensus estimate from the December Blue Chip forecast.
We continue to expect the unemployment rate to resume its
uptrend going forward, perhaps peaking in early spring. With
our projected unemployment rate still close to 10 percent at
the end of next year and tame core inflation, the Federal
Reserve will likely keep the fed funds rate at its current level
through most of 2010.
Despite the encouraging news from the labor market, there are still plenty of reasons to be cautious about the pace of
economic recovery. During the past month, the rate of improvement for manufacturing activity has slowed. Industrial
output rose in October but at a much slower pace than in the third quarter, as automakers cut output for the first time
since June. The slowdown in manufacturing is not surprising, as it is unlikely that activity can surpass the strong
performance in the third quarter, which was boosted by auto production.
Other data on manufacturing have shown slowing activity. New orders for durable goods fell in October. Core capital
goods orders, which are nondefense capital goods excluding aircraft and are a proxy for future business investment in
equipment and software in the GDP report, fell sharply during the month. This marks the third drop in the last four
months. Durable goods orders data are very volatile and are generally subject to significant revisions, so we do not
question the sustainability of the recovery of capital expenditures at this point. A national manufacturing survey also
added concerns about the strength of the manufacturing rebound. The Institute for Supply Management (ISM)
manufacturing index fell in November but still remains in expansion territory. Overall, we believe that incoming data will
continue to support continued growth in manufacturing.
One piece of news that surprised on the downside came from the other ISM survey. The non-manufacturing index, which
measures activity in the service sector, fell in November for the second consecutive month. The index has now slipped
back below 50 – indicating contracting service activity. This year, the index stayed above 50 only in September and
October. The performance of the non-manufacturing index underscores the fragile nature of this recovery.
News was mixed on the consumer front. Real consumer spending rebounded in October, rising a strong 0.4 percent and
partially reversing the 0.7 percent drop in September. In addition, auto sales showed signs of stabilizing, improving
slightly in November. This upbeat news of the rebound in consumer spending was tempered by early indicators of retail
sales in November. After posting year-over-year gains in September and October, chain-store sales stayed relatively flat
from a year ago. This was disappointing considering that last November chain-store sales suffered the largest year-over-
year drop on record. A slowdown in consumer spending growth in the current quarter is expected as the impact of the
“cash-for-clunkers” program reverses.

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The GDP revision showed that consumers received more income in both the second and third quarters than first reported.
Personal income, which includes labor compensation, dividend income, and transfer income (e.g., money paid to social
security recipients from the fiscal stimulus), posted a significant upward revision. As a result, the saving rate – personal
saving as a share of after-tax income – was revised much higher. The saving rate for the third quarter was revised
upward to 4.5 percent – 1.2 percentage points higher than previously recorded. This implies that consumers appear to
have been somewhat less stressed than previously believed. The saving rate, at 4.3 percent in November, has trended
up from less than one percent in April 2008, as households attempt to save more out of income to reduce their debt
burden.

Financial market conditions have eased further. The Federal

Reserve’s purchase programs of agency debt and mortgage-
backed securities have helped narrow the spread between
conforming mortgage rates and Treasury yields to the level
seen before the financial crisis in August 2007. Corporate
bond spreads continue to narrow but at a slower rate than
seen earlier. Nonetheless, small businesses and consumers
continue to face difficulties in obtaining credit.

After a 15-year stretch of rising consumer credit from April

1993 to July 2008 (with the exception of January 1998),
consumer credit dropped abruptly, as a result of both tight
financing and weak demand. In October 2009, consumer
credit balances fell for the 12th time in the past 13 months,
albeit at a slower pace than in recent months. The streak of
declines was not surprising and is a part of an ongoing
consumer deleveraging process as households are
financially strapped in a weak labor market. The smaller
drop in October was a result of a jump in non-revolving credit
(auto loans) – the first gain since August. Easier terms on
new-vehicle loans may be responsible for the increase in
borrowing. The average rate on auto finance company loans
for new vehicles in October was the lowest since April and
less than half the peak reached a year ago, according to the
Federal Reserve. Revolving credit balances declined for the
13th consecutive month.

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 Stock prices have increased substantially since their March
low, helping to increase household wealth. Home prices also
increased consistently in the spring and summer. As a result,
household net worth (assets minus liabilities) posted a gain of
$2.6 trillion in the third quarter after a $2.3 trillion gain in the
second quarter. However, the gains during the past two
quarters paled in comparison to the massive destruction of
more than $14 trillion that occurred during the recession.

The picture of home prices has turned less encouraging in the

fall. The most optimistic measure was the Case-Shiller
Composite 10 and Composite 20, which increased in
September for the fourth consecutive month, albeit at the
slowest pace during that period. The Federal Housing
Finance Agency seasonally adjusted Purchase-Only Index
was essentially flat in September after declining in August. By
contrast, the LoanPerformance seasonally adjusted Home
Price Index fell in September, following gains of at least one
percent in each of the previous four months.
Homebuilding activity took a big hit in October. Single-family
starts fell sharply, reaching the lowest level since May, while
multifamily starts plunged to a record low. Given the
expanded homebuyer tax credit for homes with contracts signed by the end of April 2010, activity should rebound in
coming months. Permits have shown a steady trend, with single-family permits holding in a tight range during the last four
months.
New home sales rose in October for the first time in three months. Even though single-family starts and new home sales
reached their troughs at the beginning of the year, home builders’ confidence has been moving sideways at low levels
since July, according to the National Association of Home Builders Housing Market Index. With lukewarm demand and
plenty of excess housing supply, builders have remained cautious.
Marking a sharp contrast to home construction and new home sales is existing home sales. Existing homes have
received support from bargain-priced distressed sales, and new homes are having a hard time competing. October total
existing home sales posted both record monthly and year-over-year gains since record keeping for condo sales began in
1999. The jump in sales likely reflected the pre-extension rush to close sales before the tax credit expired at the end of
November. Leading indicators for the near term showed conflicting signals. Pending home sales, which measure
contract signing, increased in October; however, activity measuring purchase mortgage applications fell sharply between
mid-October and mid-November. Some of the divergence in the index can be explained by cash sales, which are not
captured by the mortgage applications data. However, the percentage of cash sales has been declining between July and
October, according to the Campbell/Mortgage Finance Monthly Survey of Real Estate Market Conditions.

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It is likely that the decline in the purchase index in October partly reflected the expectation that the tax credit was expiring,
which pushed forward purchase applications. Since mid-November, when the tax credit was extended, the purchase
index has increased for three consecutive weeks.
We expect home sales to slow somewhat in coming months from the unsustainable October pace. The expanded
homebuyer credit, combined with historically low mortgage rates, should support a strong sales pace through the first half
of next year. We expect sales to start picking up more strongly by the end of next year, as the labor market shows
sustained improvement. Housing is not out of the woods yet, however. Mortgage credit quality continues to deteriorate.
During the third quarter, 14.1 percent of loans outstanding were in delinquency or foreclosure, according to the Mortgage
Bankers Association National Delinquency Survey. Some of these troubled loans will end up on the market, adding to the
already large excess supply.
The mortgage market should turn into more of a purchase market next year. With projected increases in home sales and
more moderate declines expected in home prices, purchase mortgage originations are expected to increase about 12
percent in 2010. With a projected moderate economic expansion, mortgage rates should trend up modestly throughout
2010. Rising mortgage rates would decrease refinance originations. For all of 2010, total mortgage originations should
decline to $1.32 trillion from a projected $1.95 trillion in 2009, with a refinance share of 48 percent. After increasing every
quarter since record keeping began in 1952 until the second quarter of 2008, nominal single-family mortgage debt
outstanding has been steadily declining more recently, partly because of rising foreclosures (i.e., charged-offs). We
expect the decline in mortgage debt outstanding to continue through all of 2010, marking three consecutive annual drops.

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Doug Duncan and Orawin T. Velz
Economics and Mortgage Market Analysis
December 10, 2009

Opinions, analyses, estimates, forecasts and other views of Fannie Mae's Economics and Mortgage Market Analysis
(EMMA) group included in these materials should not be construed as indicating Fannie Mae's business prospects or
expected results, are based on a number of assumptions, and are subject to change without notice. Although the EMMA
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Changes in the assumptions or the information underlying these views could produce materially different results. The
analyses, opinions, estimates, forecasts and other views published by the EMMA group represent the views of that group
as of the date indicated and do not necessarily represent the views of Fannie Mae or its management.