As the economy turns: Mark Zandi presents a semiannual economic forecast and the impact for bankers

The economy is increasingly buoyant, and interest rates are on the rise, which signals a significant shift for commercial banks. Long-booming mortgage lending will soon weaken substantially, while long-struggling credit-card and commercial-and-industrial lending will soon improve.

The economy's strength is evident across a host of indicators. Real GDP is expanding at a robust 5% clip, with consumers, businesses, government, and even our foreign trading partners adding to growth. Growth is rarely this strong or as broad based. Even the job market is fast improving. The economy has created nearly a million jobs since job growth resumed last summer, and unemployment and underemployment will soon decline in earnest.

Economic prospects for the remainder of this year and next are strong. Fiscal and monetary stimulus remain potent and productivity gains robust. The benefits of the productivity gains are accruing to businesses in the form of surging profits. After-tax profit margins have never been as wide. Businesses are responding to their heightened profitability and surging cash flow by investing and hiring. Information technology investment is as strong as it has ever been, and even investment in traditional manufacturing is on the rise. Most important, however, businesses are adding aggressively to their payrolls. This is resulting in improving household incomes and cash flow, which will support continued-solid consumer spending. The fragile economic recovery has evolved into a self-sustaining economic expansion.

With the better economy and job market have come higher interest rates. Long-term rates have risen sharply since the spring, with 10-year Treasury yields up 100 basis points--coming close to 4.75%. Fixed mortgage rates are up nearly as much, to well over 6%. The Federal Reserve is on track to begin tightening monetary policy soon, most likely in late June.

While the catalyst for the rise in rates is the improving job market, surging energy and commodity prices are fanning investors' inflation concerns. Oil prices are near record highs, while prices have doubled and even tripled for commodities ranging from steel and copper to rubber and various agricultural products.

An added impetus for higher rates is the gaping federal budget deficit. According to the nonpartisan Congressional Budget Office, cumulative budget deficits over the next decade will total some $2 trillion even assuming that the economy remains solid throughout and that the Bush tax cots expire as currently legislated. If the tax cuts become permanent, as the President has proposed, then the deficits will total $3.5 trillion, and if the one-year fix to the alternative minimum tax becomes permanent, as seems likely, the deficit will amount to a whopping $4 trillion--something that bond investors have yet to incorporate into their thinking. All this will occur as corporate credit demands begin to increase in coming months and bump up against the federal government's own large and expanding credit needs.

Rates could receive another boost when the Chinese eventually revalue the yuan. Not only will this add to inflationary pressures here in the U.S., it will dampen voracious Chinese central bank demand for Treasury debt. The Chinese have been particularly avid buyers of Treasury debt, as they rake in dollars through their burgeoning trade surplus with the U.S.

In the long run, abstracting from the ups and downs in the business cycle, the federal funds rate target is expected to be near 4.5%, which is equal to expected long-run nominal GDP growth. Yields on 10-year Treasury bonds will be closer to 5.5% and fixed mortgage rates will near 7%. This reflects the inflation-risk premium embedded in long-term rates and the prospect of persistently large deficits and more reluctant foreign Treasury buying. Rates, will of course, be higher at times when the economy is operating above its capacity and inflationary pressures are most pronounced.

A stronger economy and higher interest rates signal a shift within commercial bank lending. The most obvious casualty of higher interest rates will be mortgage lenders. Heretofore booming mortgage refinancing activity is already waning. A fixed mortgage rate exceeding 7% will all but dry up the pool of potential refiers, or those who can recoup their transaction costs within a reasonable period.

The purchase origination market will also weaken substantially. What had been exceedingly low mortgage rates induced renters into homeownership and drove house prices up rapidly. Many renters who would have purchased a home in the next one to three years under a more normal rate environment have already done so. Higher rates will result in significantly weaker home sales and origination volume.

House prices in currently high-flying markets like California, the Northeast corridor, and much of Florida are highly vulnerable. House price expectations in these areas are extraordinarily strong, which is resulting in increasingly speculative behavior. These expectations, and thus actual house prices, could change quickly with higher rates.

A weaker housing and mortgage market will work to the benefit of other household lenders. If households are no longer able to borrow easily or cheaply against their homes, they will turn back to their credit cards and other sources of credit. A better job market should, however, support better consumer credit quality. All of this may take a few months or even several quarters, but credit card lenders struggling to maintain outstandings will experience substantive growth by this time next year.

Bank auto lenders also will experience better times. Although vehicle sales will at best hold their own, bank lenders are in a position to take lending share from the captive finance companies, who have used their low cost of funds to offer aggressive financing terms. Such terms become untenable with higher rates. Used-vehicle prices, residual values, and credit quality are also poised to improve as the reduced leasing activity of recent years puts increasingly less pressure on the used-car market.

The turnaround for commercial and industrial lenders will take a bit longer, but their recovery should take full shape by the middle of 2005. The principal weight on C&I lending has been businesses' surging profits and cash flow. When businesses are flush, there is little reason to borrow; even from their friendly banker. Indeed, even now, despite the rebound in investment spending, internally generated cash flow of non-financial institutions continues to strengthen.

With continued strong but very plausible economic growth, however, businesses will start depleting their cash reserves by the middle of next year. A significant turn in cash flow also will occur at the start of 2005 as the current accelerated depreciation benefits that businesses currently enjoy will expire. Any investment made by businesses this year can be depreciated rapidly, lowering tax bills and lifting cash flow. Next year, the accelerated depreciation ends, and businesses will have to accelerate their depreciation. Tax bills will thus rise and cash flow will weaken. It is then that C&I lending will expand.

In summary, after several lean years, the economic expansion is approaching its sweet spot. Growth is strong, and the expansion is now self-sustaining. Interest rates are thus on the rise, which will create significant adjustments for the broader economy. Rate-sensitive parts of the economy, such as housing, will weaken measurably. The implications for lenders are enormous. Mortgage lenders face a significant comeuppance, while struggling credit-card and C&I lenders will experience a long anticipated revival.

Contact Zandi by e-mail: [email protected].

[C] 2004 by RMA. Mark Zandi, Ph.D., is chief economist at Economy.com in West Chester, Pennsylvania.

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