The recession is over…technically.

Californians who consider the condition of the state’s economy today will generally agree we are in the throes of an ongoing real estate recession. To those who are unemployed or delinquent on their mortgage — millions of Californians — the term recession is synonymous with personal financial hardship.

The media laughed in the face of the National Bureau of Economic Research (NBER) when they recently announced the Great Recession officially ended in June 2009. Consumer confidence remains desperately low as the weak employment numbers that began in 2007 still plague almost every California industry, indicating to society that we have a long way to go before we stabilize.

Almost two years after the supposed “end” of the recession, the public remains flooded with stories emphasizing the plight of the common man who has not yet escaped the clutches of economic depression. Yet, even so, most economists agree June 2009 properly marks the official end of the economic cycle that reared its ugly head in December 2007.

Obviously, there is a major disconnect between market analysts and the unemployed (and underwater) constituency. Over 1.5 million Californians are still struggling to find replacement jobs and pay their bills, making it nearly impossible for any of them to believe the economy is approaching recovery.

So are we or aren’t we done with the Great Recession? To fully and accurately answer such a question, we must first conclude what exactly a recession is and who decides when one begins or ends.
What is a recession?

The NBER defines a recession as a period of at least three quarters when “a significant decline in economic activity spreads across the economy,” taking multiple economic factors into account, such as employment and gross domestic product (GDP).

The precipitating event of a recessionary period is the money-tightening activity of the Federal Reserve (the Fed). The Fed directly influences the three-month Treasury bill (T-Bill), which represents the short-term interest rate and determines the base price of borrowing money for the short-term.

This apolitical entity can stimulate business and economic growth to stave off price deflation and job losses by lowering short-term interest rates. Conversely, the Fed fights inflation and overheated employment by continually raising short-term interest rates until the correction is achieved.

Further, the three-month T-Bill is juxtaposed with the ten-year Treasury note (T-note) rate. It is the bond market investors, not the Fed, who set the rate for returns on their ten-year investments in government notes. Bond market investors take into account the Fed’s management of the short-term rate (called monetary policy) to forecast the future rate of inflation, future demand for money and the desired fixed rate of return needed on their investment.

The T-bill and T-note rates form the yield spread.

In tandem, the T-bill and T-note rates form the yield spread, the difference between the three-month T-bill controlled by the Fed and the ten-year T-note controlled by market investors.

When bond market investors forecast less future growth as a result of the Fed’s upward short-term rate activity, they accept a lower long-term rate. Thus, the yield spread narrows, forecasting a less vigorous economy in the near future. On the other hand, a widening yield spread indicates much less danger of a future decline in business activity and demand for money.

When a yield curve goes negative — short-term rates exceed long-term rates — one can be confident we will be in a recession within 12 months. This held true for the 1989 recession, the 2001 recession, the 2008 Great Recession and all prior recessions back to World War II.

Why does the Fed “create” a recession?

The Fed decides to raise short-term interest rates when certain red-flag conditions indicate the economy must be slowed. An excess demand for labor indicates business is booming, prices are up and job salaries are increasing too quickly for the market to remain stable. If consumer price inflation climbs beyond 2%, the Fed considers action to correct it.

In 2004, at the height of the Millennium Boom, the Fed began to raise short-term interest rates in an effort to slow the economy and thus tame price inflation and an overheated job market. Eventually, the yield curve inverted in mid-2006 as short-term rates exceeded the long-term rates. Just over one year later, in December of 2007, an official recession was declared after the NBER recorded three consecutive quarters of economic downturn. By then the Fed had already begun dropping the short-term rates, as the correction they sought was underway.

Who decides when a recession begins or ends?

June 2009 marked the third consecutive quarter of economic upturn, making it the officially end of the Great Recession.

The everyday homeowner reads the NBER’s declaration and looks for a fully stabilized housing market and employment rate. Those conditions were certainly not marked by that date. The NBER merely recorded June 2009 as the official moment in which their definition of a recession no longer applied to the current economy. They did not intend to imply the economy had fully recovered, but rather that the economy was not getting worse.

The NBER did not intend to imply the economy had fully recovered, but rather it was not getting worse.

As the creation of jobs continues to push California toward eventual upturn, agents and brokers can expect the momentum of sales to experience a slight deceleration around 2013-2014. By then, the Fed will likely need to raise interest rates to stabilize the recovery so it doesn’t expand too quickly. Employment levels will return to prior 2007 peak levels by 2016 if all goes according to the Fed’s plan.
Congress and the Administration also have a hand in the performance of the economy, and their agenda continues to influence market growth.

Delusions of grandeur

Common misconceptions about recessions only serve to make them more mysterious. The media’s coverage of the burst housing bubble and economic crash is largely responsible for the delusions of uncontrollable, unpredictable economic chaos which have inculcated the minds of the masses who know little about the science of economics or the operations of the Fed. Likewise, whispers of the dollar failing and noise about the return of a gold standard have no basis in reality.

In the spirit of spreading rational truth, first tuesday would like to address and refute some commonly misguided assumptions regarding this Great Recession.

Myth #1: Recessions are random.
The current economic cycle is a product of the difficult but necessary decisions made by the Fed in order to keep inflation at bay and quell the overindulgence of the Millennium Boom. A recession cannot strike at any time, but in fact follows a pattern we have seen throughout history time and time again. It is because of the consistent historical precedent of past recessions that first tuesday can confidently predict when employment rates and housing prices will return to prior levels.

Myth #2: The end of a recession means the economy has recovered.
Three quarters is not enough time to distinguish whether an actual real estate recovery is underway, or if we are just experiencing a “dead cat bounce” followed by a double-dip recession. Optimists, proceed with caution.

Myth #3: Recessions cannot be anticipated.
Use of the yield spread to predict what the economy will look like one year forward is an excellent tool for agents to use when discussing the likelihood of a recession with their buyers or sellers. You can assure them the coming year will foster recovery by explaining how to read and apply the wisdom built into the yield spread.

Copyright © 2011 by first tuesday Realty Publications, Inc. Readers are encouraged to reprint or distribute this information with credit given to the first tuesday Journal Online — P.O. Box 20069, Riverside, CA 92516.

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