The U.S. economy has registered five consecutive quarters of economic growth since the recession ended, yet there is a great deal of concern about the outlook for 2011. The 2.9% average increase in real GDP over these five quarters pales in comparison with recoveries of the post-war period prior to 1990. One major factor in this subpar economic recovery is the contraction of bank credit, which has a strong positive correlation with gross domestic purchases.
Following the housing market debacle and the long and deep U.S. recession, the sum of loan charge-offs and delinquent loans at commercial banks rose to an unparalleled $531 billion by the end of 2009, up from $93 billion at the end of 2005. This large setback left banks with impaired balance sheets and severely restricted their ability to lend. Although the Fed injected vast amounts of reserves to stabilize the banking system, the monetary transmission mechanism was dysfunctional, and bank credit fell 6.5% in 2009, the second and largest decline in the post-war period.
Under other circumstances, bank credit allows those entities borrowing from the banking system to increase their purchases of goods, services and assets without requiring any other entity to simultaneously reduce its purchases. The staggering size of the credit contraction reflects the broken monetary transmission mechanism that has prevented a robust economic recovery.
The TARP legislation and several programs initiated by the Fed allowed banks to strengthen their balance sheets following the financial market crisis. The banking system is adequately capitalized at the present time, but banks have accumulated large amounts of excess reserves in anticipation of higher capital requirements as the Dodd-Frank legislation is implemented. Banks are also mindful of the delinquencies and loan losses from the commercial real estate sector that are likely in 2011 and are building up excess reserves to prevent balance sheet stress.
Despite this continued uneasiness, signs of improvement have emerged. Bank credit has posted gains in each of the four months ended in October. Of the two main components of bank credit, purchases of securities and loans, the former has advanced while the latter shows significantly less negative readings. Historically, loans on the books of banks grow only in later stages of an economic expansion, which we anticipate should be visible in 2011.
The U.S. economy grew at an annualized rate of 2.5% in the third quarter, and we expect 2010 to close with a similar gain in the fourth-quarter. Assuming bank credit continues to advance in 2011, we expect the pace of growth to be higher in the second half than in the first half.
Real GDP should post growth upwards of 3% in the third and fourth quarters of 2011, and should show a gain of 3% in 2011 on a Q4-to-Q4 basis, vs. a 2.6% increase in 2010. Consequently, the unemployment rate should trend down meaningfully, to roughly 8.75%, from the current reading of 9.8%. The Consumer Price Index is expected to move up 1.7% in 2011, after a 1.1% increase in 2010 on a Q4-to-Q4 basis.
There are two recent and noteworthy developments that should support the growth of bank credit in 2011, thereby enhancing overall economic growth. First, the Fed's November survey of senior loan officers suggests bankers are more willing to lend to households and businesses, with underwriting standards less stringent compared with their position following the collapse of Lehman Brothers and the period soon after. The significant improvement in bankers' views supports our predictions of growth in bank credit during 2011.
Second, the Fed's new round of purchases of Treasury securities, amounting to $600 billion, the so-called quantitative easing or QE2, should have a positive influence on credit growth. QE2 is not likely to involve reductions in other parts of the Fed's balance sheet. This is different from the QE1 experience, from November 2008 through March 2010, when the Fed's purchases were offset by reductions in other items on its balance sheet. Also, when QE1 was in place, the enormous reduction in bank credit more than offset the Fed-created credit and resulted in a substantial decline in net credit. This time around, the combination of expanding bank credit and the positive impact of QE2 should raise overall credit and translate into a higher pace of economic activity in 2011 than in 2010.