Although some banks may be distressed, most are well capitalized and should be able to absorb the losses. According to the most recent data available, as of September 30, 2007, the book value of equity capital for banks whose deposits were insured by the Federal Deposit Insurance Corporation (FDIC) totaled more than $1.3 trillion. In addition, the FDIC has indicated that of the 8,560 institutions covered, the vast majority (8,481) are well capitalized. Those well-capitalized banks, furthermore, hold 99.8 percent of the industry’s assets. Only nine institutions, holding a trivial percentage of the industry’s assets, are undercapitalized. Another 70 institutions, holding 0.2 percent of assets, are considered adequately capitalized.

Still, the large size of potential losses suggests that some banks, abroad as well as here, will absorb losses that could impair their lending.¹³ On the basis of current discounts on subprime MBSs, expected depreciation in home prices, and past experience with defaults, some private-sector analysts estimate that mortgage losses over several years could be $300 billion to $400 billion. Because those losses will also be shared globally by investors, including hedge funds, pension funds, and other investment funds, it is unlikely that the banking system as a whole will be imperiled.

Credit losses have also affected the potential lending capacity of Fannie Mae and Freddie Mac. Their concentration in the prime mortgage market serves as an insulating factor, but they hold about $230 billion in subprime and Alt-A mortgages.¹⁴ Their credit losses have lowered their capital cushions to just about $3 billion, on top of the $73 billion in capital currently required to safeguard $1.6 trillion of balance-sheet assets and $3.3 trillion of off-balance-sheet guarantees of mortgage-backed securities. That modest cushion leaves little capacity to absorb further losses. Consequently, Freddie Mac has announced that it will raise $6 billion in new capital and cut its dividend in half. However, even if the enterprises chose not to raise more capital, they could continue guaranteeing MBSs as long as they reduced their portfolios of mortgages, because the capital requirements for the mortgages held on their balance sheets are about five times higher than the requirements for their guarantees. Because the enterprises’ guarantees with their implicit federal backing are the source of lower borrowing costs in the conforming mortgage market, any problems that they encounter are unlikely to affect that market but could affect their ability to buy more subprime and Alt-A mortgages.

The Response of Monetary Policy

As the extent of the turmoil in financial markets became clear in August, central banks in both the United States and elsewhere took action to maintain liquidity. Starting on August 10, the Federal Reserve injected $24 billion in temporary reserves into the U.S. banking system, a larger-than-usual amount, by accepting greater-than-normal amounts of mortgage-backed securities as collateral (see Figure 10). That action included a tacit temporary suspension of targeting the federal funds rate, as it was permitted to trade below the 5.25 percent target set on August 7. That approach continued until the Federal Reserve reduced the target to 4.75 percent on September 18. On August 17, the Federal Reserve also reduced the discount rate from 6.25 percent to 5.75 percent, and it extended the length of loans to 30 days and allowed borrowers to renew them.¹⁵ On October 31, the Federal Reserve again cut the target federal funds rate by another 25 basis points, to 4.5 percent (see Figure 11).

The trouble in the U.S. subprime mortgage market also directly affected banks in other countries that had invested heavily in U.S. securities backed by subprime mortgages or were relying on short-term interbank financing (which became disrupted by the troubles in the mortgage markets) for longer-term loans. The European Central Bank (ECB), the Bank of Japan, the Bank of Canada, and the Bank of England all have injected substantial amounts of liquidity into their countries’ financial markets to contain the credit crisis. For example, on August 9, the ECB provided an unprecedented amount equivalent to $129 billion, which the Bank of Japan followed the next day with $9 billion. On September 6, the ECB injected $59 billion into temporary reserves. Even the Bank of England, which was reluctant to intervene earlier, announced on September 19 that it would inject $20 billion into money markets, in a bid to bring down short-term interest rates, which had risen after the Northern Rock bank experienced difficulties in refinancing. So far, those foreign central banks have not yet cut their interest rates, but they have held off planned increases.

The resurgence of market jitters in November has prompted the central banks to take or announce new steps intended to calm the markets. For example, that month, the Bank of Canada provided to money markets funds totaling more than $3 billion to bring the overnight rate down to its target (4.5 percent). On November 26, the Federal Reserve announced that it would extend the length of loans to bond dealers to ease funding pressure on banks through the end of the year. On November 29, the Bank of England announced that it would inject about $20 billion to alleviate concerns about overly tight credit conditions. Earlier this month, the ECB also announced that it would inject $85 billion in three-month loans on November 23, to be followed by another $85 billion on December 12.

Developments in oil markets could also affect the macroeconomic outlook, although their impact to date has been modest. In 2007, the price of crude oil increased by over 60 percent, reaching almost $100 a barrel in recent weeks, an inflation-adjusted level not seen since the 1980s (see Figure 12). Supply and demand fundamentals account for much of the recent increase in crude oil prices, but geopolitical tensions and related increases in speculative and precautionary demand for oil have also exerted upward pressure on prices. The increase in crude oil prices has pushed higher the prices of petroleum products such as gasoline and heating oil.

The Energy Information Administration (EIA) of the Department of Energy projects that world consumption of crude oil will have increased in 2007 by about 1.1 million barrels per day, to 85.8 million barrels per day.¹⁶ China, India, and nations in the Middle East together account for over 75 percent of the projected increase. Although the United States accounts for about 25 percent of global oil consumption, it accounts for much less of the recent increase: Only about 10 percent of the increase in 2007 is attributable to the United States.

That increase in global demand comes against the backdrop of slow growth in world oil production. According to EIA’s forecasts, total production will be about 200,000 barrels per day higher in 2007 than in 2006. Total production by nations outside of the Organization of Petroleum Exporting Countries (OPEC) will increase, but that increase will have been almost completely offset by the organization’s cuts in production in November 2006 and February 2007.¹⁷ Crude oil prices have declined in recent days to below $90 a barrel, on the basis of expectations of a near-term increase in OPEC’s production, though the organization has yet to confirm such an increase. With such limited growth of supply, the increase in crude oil consumption is being drawn from privately held inventories. While tight markets result in elevated prices, lower inventories reduce the buffer against uncertainties about the supply and increase the potential for price volatility.

Over the longer term, there is some concern that future supply may not be able to keep pace with increased demand and that prices could rise further. World consumption is expected to continue to grow, reflecting large growth in demand in China, India, the Middle East, and elsewhere. The International Energy Agency forecasts growth of world petroleum consumption of about 2 percent per annum in the years ahead.¹⁸ However, the supply may become increasingly limited as crude oil from existing reserves becomes harder and more expensive to access. In some areas, for example, the North Sea, Mexico, and Venezuela, production has been unresponsive to rising prices. But analysts differ on whether the market as a whole is constrained by a limited accessible supply or whether specific factors, such as political unrest in Nigeria or slow development of new central Asian oil fields, account for relatively flat production despite rising prices. Regardless of the underlying cause of a sluggish supply response, prices will increase if future increases in demand are not matched by a growing supply.

Some analysts argue that the rise in the price of oil also reflects increases in speculative and precautionary demand for oil. For example, Middle East tensions could disrupt the supply and drive prices higher, and some of that risk is currently reflected in the market price. Similarly, some investors may conclude that holding crude oil is a better investment than other assets.

Looking to the future, both EIA’s price forecasts and futures prices available at the New York Mercantile Exchange (NYMEX) suggest that crude oil prices will decline from current levels next year, though prices are still projected to remain high relative to historical experience. In its most recent forecast, EIA estimates that the prices for West Texas Intermediate crude oil will be about 11 percent lower at the end of 2008 than at the beginning of that year.¹⁹ That projection is somewhat greater than current NYMEX futures prices; the current price for December 2008 is about $85 per barrel, or about 4 percent below the January 2008 prices.²⁰

Gasoline

The price of gasoline has broadly reflected the rise in crude prices since the beginning of the year. As of late November 2007, the weekly average retail price for all grades of gasoline in the United States was about $3.15, or about 32 percent higher than it was at the beginning of January. (See Figure 13). However, short-term movements in gasoline prices did not necessarily reflect movements in crude oil prices throughout the year. As is typical, average gasoline prices peaked during the late spring in anticipation of increased summer driving. By late August, average prices for retail gasoline in the United States declined by nearly 15 percent from the spring peak even as crude oil prices had risen by about 10 percent.²¹ Since August, both crude oil prices and average retail prices for gasoline have increased.

Heating Oil and Natural Gas

According to current data from EIA, average real prices for heating oil are about $3.30 a gallon, about 38 percent higher than they were a year earlier.²² In contrast, winter 2006–2007 heating oil prices were approximately unchanged from those of the previous winter. By EIA’s projections, heating oil prices will decline in 2008 by about 8 percent, approximately the same amount that the agency predicts for crude oil prices. However, the severity of the winter will be a key determinant of whether heating oil prices continue to increase over the next several months.

Natural gas prices have fluctuated throughout the past year and currently stand at about $8 per million British thermal units, a level approximately consistent with prices a year earlier. EIA estimates that natural gas prices will grow by about 3 percent in 2008,²³ while NYMEX futures indicate greater growth of about 11 percent.²⁴

Macroeconomic Effects

The historically high crude oil and related energy prices have had a limited impact on the U.S. economy to date. At the consumer level, individuals tend to be inflexible in their use of gasoline, at least in the short term. Estimates of the short-run elasticity of demand for gasoline suggest that a 10 percent increase in the price of gasoline will cause the consumption of gasoline to decline by 0.5 percent or less. According to CBO’s research, higher gasoline prices have induced only a small change in driving patterns. Individuals are buying somewhat more fuel-efficient vehicles than in the past, and the share of sport utility vehicles has declined as the share of passenger cars has increased. But even if high prices persist, the full effect of that higher efficiency on gasoline demand will not be completely realized for many years because fully replacing the automobile fleet takes about 15 years.

The relatively modest effects on the economy from higher oil and related prices may seem puzzling to those who remember the substantial impact from the oil price shocks of the 1970s. At that time, however, monetary policymakers had been unable to control inflation in the years before energy prices rose, and many other aspects of the structure of the U.S. economy made it less able to respond to energy price shocks than it is today.²⁵

The current-account balance has stabilized in recent years and real net exports have increased sharply since early last year, providing an important offset to the weakness of housing spending. But after increasing for many years, the nation’s current-account deficit has become unsustainably large. Between 2000 and 2005, it grew from about $400 billion to about $800 billion. Since then, it has remained roughly constant, even though the cost of oil imports has risen sharply. Indeed, with oil excluded, the deficit has begun to decrease since 2005. The stabilization of the current account reflects a slight increase in the real growth of exports and a sharper decrease in the real growth of imports. Thus far, the adjustment in the current account has occurred in an orderly way without major disruptions of exchange markets.

Both strong growth abroad and depreciation of the dollar have played roles in stabilizing the current account. The economic growth of major U.S. trading partners has been stronger than expected so far this year, mainly because of the strength of emerging economies. The problems in the U.S. subprime mortgage market, though they have caused a credit squeeze in advanced economies, appear to have channeled capital to some emerging economies, especially those of Brazil and India, supporting their domestic growth and imports and adding to the growth of their asset prices and exchange rates. Economic growth in other countries, however, appears to have slowed since the summer, as industrial economies grapple with the problems in financial markets, the sharp rise in oil prices, and the appreciation of their currencies against the dollar.

The dollar, which has been on a downtrend since early 2002, has dropped by more than 5 percent against the currencies of the country’s major trading partners since midsummer. The recent more rapid decline probably largely reflects the consequences of the financial strains in the United States, through the following channels:

• The Federal Reserve cut interest rates more aggressively than most other central banks have, lowering the rate of return on U.S. short-term securities;
  
  
• Investors remained concerned about the dollar’s status as the main reserve currency for central banks, and some countries are rebalancing their official portfolios and reducing the share of dollar assets; and
  
  
• Fear of a U.S. recession and uncertainty about the true scale of U.S. corporations’ exposure to the fallout from the financial turmoil may also have reduced foreign demand for U.S. stocks and bonds.

Eventually, such a large movement of exchange rates would be expected to have some impact on consumer prices, but little impact has been seen yet. Several studies have observed that the "pass-through" from exchange rates to U.S. prices has recently been smaller than it used to be, perhaps because foreign exporters have so far been able to absorb a large part of the dollar’s depreciation without changing U.S. prices much.²⁶ However, there is a limit to how much compression of profits those exporters can absorb, and eventually more of the decline in exchange rates is likely to be passed through to prices. That limit—whose position is unknown—is likely to be reached more quickly when exchange rates depreciate more rapidly.

Because consumption accounts for such a large share of overall economic activity, the economic outlook will be substantially affected by what happens to consumer spending. The turmoil in credit markets could affect consumption because consumer and mortgage loans may be more difficult to obtain, because the decline in house prices reduces consumer wealth, and because consumer confidence about future economic activity may be diminished. Moreover, continued weakness in stock markets also would work to reduce consumption spending somewhat.

So far, there is little direct evidence of any significant slowing in consumption. Through the third quarter of this year, real personal consumption expenditures had not moved to a significantly lower trend growth path (see Figure 14). The first look at overall consumer spending in October, which came out last Friday, indicates weaker growth, but some of that weakness may reflect unseasonably warm temperatures that reduced heating needs and purchases of seasonal clothing and shoes. Despite the problem of delinquencies of subprime mortgage loans, delinquency rates on consumer loans at commercial banks have moved up only slightly in the past year and are not signaling major problems.

The apparent resilience of consumption is somewhat less reassuring in light of some other factors. First, consumers’ energy bills have risen significantly this year, by roughly $80 billion (at an annual rate) in the first half of the year, which may force consumers to cut back on other spending. Although energy costs fell by about $18 billion between June and September—just as the financial turmoil emerged—oil and gasoline prices have risen again since September. Second, the effect of weaker house prices and the lower stock market may not have yet filtered through to consumer spending. As house prices continue to decline, they may affect consumer spending because houses are the main source of collateral for loans (mortgages and home equity lines) to consumers. But such effects are likely to take some time to occur. Third, the Federal Reserve reports that commercial banks have tightened their lending standards and terms on consumer loans other than credit cards and on residential mortgage loans, including prime mortgages.

Moreover, consumers’ attitudes have deteriorated this year and suggest that a broader slowing of economic activity from its pace during the middle of this year may be in the offing. The consumer sentiment index, created by the University of Michigan, fell to 76.1 in November, its lowest level since the aftermath of the 2005 hurricanes (see Figure 15). Higher energy prices and continued weakness in the housing market continue to depress consumers’ assessments of current conditions. The Conference Board’s index of consumer confidence also has fallen sharply since the summer. Both of those entities’ indexes of consumers’ expectations also have fallen this year and are at levels that, if maintained, appear to be consistent with weak growth in consumer spending.

Recessions are notoriously hard to forecast, so it is not surprising that very few forecasters have a recession in their base forecast for the near future, though most have revised down their forecasts of growth since last summer (see Table 1). From the point of view of the budget, however, the effects of being in a mild recession may not differ very much from those of being in a period of slow growth.

Table 1.

Comparison of Forecasts of Real GDP for 2008

(Percentage change, fourth quarter to fourth quarter)

Sources: Council of Economic Advisers, Department of the Treasury, and Office of Management and Budget, "Administration Economic Forecast" (joint press release, November 29, 2007, and June 6, 2007); Aspen Publishers, Inc., Blue Chip Economic Indicators (November 10, 2007, and July 10, 2007); Federal Reserve Board of Governors, Minutes of the Federal Open Market Committee (October 30-31, 2007), and Monetary Policy Report to the Congress (July 18, 2007); Global Insight, Inc., U.S. Economic Outlook (November 2007 and July 2007); Macroeconomic Advisers, LLC, Economic Outlook (November 21, 2007, and July 10, 2007); National Association for Business Economics (NABE), NABE Outlook (November 2007 and May 2007).

Notes: GDP = gross domestic product.

The Blue Chip consensus is the average of about 50 forecasts by private-sector economists. The forecast from the Federal Reserve is termed the central tendency, which reflects the most common views of the Federal Open Market Committee. The NABE Outlook is a survey of about 50 professional forecasters.

Forecasters currently face considerable uncertainty about what has already happened—not an unusual occurrence. ²⁷ In the third quarter of 2007, the most recent for which data are available, real growth of GDP was reported to have been 4.9 percent at an annual rate. However, a measure of total income in the economy—which apart from measurement errors should be the same as GDP—suggests much slower growth of slightly below 2 percent.

In evaluating the possibility of a recession, forecasters must balance the negative aspects of the economy described above—the collapse of housing, the risk of contagion, and the likely weakness of consumption—against the better news from the rest of the economy. Among that better news is the improvement of the current-account balance and inflation that is still contained despite the increases in oil prices and the weakness of the dollar. Such news gives the Federal Reserve room to adjust interest rates.

One way of thinking about the probability of a recession is to look at indicators that in the past have been correlated with recessions. The best single such indicator is an inverted yield curve—which occurs when a short-term interest rate (such as the rate for one-year Treasury bills) is above a long-term interest rate (such as the rate on 10-year notes). Such an inversion has preceded every recession in the past 50 years and has given only one false signal (see Figure 16). The yield curve was inverted for much of last year and the first five months of this year It is not inverted now, but such an inversion has frequently ended before a recession starts.

Another approach is to see what people are willing to put money on. Trading on the Intrade Web site, which allows investors to trade a derivative based on a recession in 2008, in September put the probability of a recession close to 60 percent. Since then, the probability dropped to 30 percent and is now a little below 50 percent, according to that market. That indicator is a very thinly traded contract, though, and therefore may not accurately reflect the broader views of investors.

A third approach is to survey forecasters. The November Blue Chip survey asked participants about the probability of recession in 2008. While the consensus of the 10 most pessimistic forecasters thought that the probability was over 43 percent, the consensus of all responders put that probability at about 1 in 3 (up from 1 in 4 in August). No forecaster in the survey thought that a recession was the most likely outcome. Forecasters do agree, however, that the next year will see GDP growing considerably below its potential trend, and the next survey will probably reveal forecasts of lower projected growth.

In January, CBO will release its comprehensive analysis of the current economic situation and the implications for the federal budget. Pending that full analysis, a look back at what past recessions have meant for the budget provides a rough guide to what might happen in the event of a recession in the coming year. Since 1968, recessions have worsened the annual budget balance––by CBO’s rough estimate, by between about 1 percent and 3 percent of GDP from just before the cyclical peak to the second fiscal year following. In the current economy, a recession similar to those experienced over the past four decades might therefore increase the deficit by between $140 billion and $420 billion (see Table 2).

Table 2.

Budget Effects of the Past Six Recessions

(Percentage of gross domestic product)

Source: Congressional Budget Office.

Notes: In this table, the period before the peak is the fiscal year preceding the onset of a recession, and the trough is either the fiscal year containing the last quarter in which the economy was in recession or the fiscal year following that last quarter.

The adjusted deficit is calculated by removing from the actual deficit (1) all discretionary spending; (2) the effects of legislation on taxes and mandatory spending; and (3) all interest payments. In addition, the adjusted deficit has the impact of inflation attributable to progressivity (bracket creep) removed from individual income tax receipts (except for the last two recessions, because personal income tax brackets have been indexed for inflation since 1985). Finally, it includes the effect that the increase in the deficit has on debt service.

The deterioration in the budget deficit during periods of economic weakness provides a form of automatic stimulus to the economy. As the economy slows, the decline in income, payrolls, profits, and production causes tax receipts to fall relative to spending––and causes outlays, for unemployment compensation and food stamps, for instance, to rise. The combination temporarily boosts demand for goods and services, thereby helping to offset some of the macroeconomic weakness.²⁸

Fiscal policy interventions that go beyond those automatic stabilizers in attempting to boost the economy during periods of economic weakness have had a mixed track record. Although there have been examples of effective discretionary fiscal stimulus, in several other cases, attempts to stimulate demand through changes in fiscal policies have proved to be poorly timed or relatively ineffective. Part of the reason has to do with the time lag typically involved in enacting such legislative changes. Another involves the specific stimulus policies enacted in the past, as different types of changes in spending and tax policies can have substantially different effects on short-term macroeconomic demand.²⁹ Policymakers considering whether to adopt measures beyond the budget’s existing automatic stabilizers would need to carefully weigh not only the macroeconomic environment but also the lessons from past attempts at such economic stimulus.