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The economy has been in a recession for a year now. The more recent economic data show that the pace of decline has accelerated in recent months. Banks are recording ever-larger losses. Jobs are disappearing in almost every industry. Consumers are pulling back sharply on their purse strings. Ever since the bankruptcy of Lehman Brothers in September, the economy has shifted from being in a mild recession to a free fall.

In this environment, risk spreads have reached record highs. Investors have rushed to the safety of Treasury bills, sending yields down to levels not seen since the early 1930s. Banks are more concerned about their return of investment rather than their return on investment. The Fed has responded to this situation by aggressively cutting interest rates and flooding the banking system with reserves. Bank reserves are up more than 230 percent from a year ago, an unprecedented surge in liquidity. And still the banks hoard their cash.

In an environment of fear, nothing can be more beneficial than a central bank and treasury that is fearless. When no one else will lend, the public sector needs to step in and act as the lender of last resort. And this the Federal Reserve and Treasury have done with a vengeance.

Over the past year, the Fed has created an alphabet soup of special lending facilities. Credit has been extended to commercial banks and investment banks. The Fed has purchased commercial paper and taken mortgage-backed securities as collateral. The FDIC has extended guarantees to all bank deposits and money market funds. The Treasury has set up the Troubled Asset Relief Program with $700 billion in funding. The Federal Housing Authority has the HOPE project to assist distressed homeowners. Collectively, these efforts have put more than $1.8 trillion into the economy, with another $2.6 trillion in funds waiting to be deployed if needed. Another stimulus package of at least $500 billion is expected from the incoming Obama administration.

Will any of it Work?
Some of the funds will undoubtedly be misappropriated. Some may actually be counterproductive. But we have never seen the kind of monetary and fiscal stimulus that is currently being put into the economy, and not had a recovery. You can already see the shape of that recovery in the yield curve.

The yield curve is a proxy for bank margins. When banks can make money on the spreads, they lend. Credit creation generates growth. A steep yield curve means fat margins and an incentive to lend. Shown here is the yield curve for 1999-2002 and the current yield curve starting in July 2005.


Treasury Yield Curve 10 Year Treasury Less 3 Month T-Bill Rate

The curve generally leads the economy by 12-18 months as the banking system responds to changing incentives. In the 2001 recession (the brown line), the curve inverts in July 2000 and the recession started in March 2001 when the curve begins to revert, a nine-month lead.

There is some debate in economic circles about the correct dating of the recovery. The NBER puts the recovery date at November 2001. The problem with that date is that three of the four variables they look at (industrial production, employment and real income) continued to decline until March of 2003. The yield curve peaks in March 2002, a year before that recovery date.

For this cycle, the curve inverted in March 2006, the credit crisis hit 17 months later in August 2007, which some economists believe to be the start of this recession. The actual start of the recession, however, did take until December, a long 21 months from the original inversion. We are just now hitting the peak of the steepening of the curve, which would put recovery a year from now, sometime in Q4 2009. It is a little bit like reading tea leaves, and none of this is an exact science. But what it does say is that the best leading indicator of the economy is forecasting a recovery for late 2009.

To comment on this article or pose another topic for this columnist, contact Dr. Carl Steidtmann at csteidtmann@deloitte.com.