2009: Year of the Thaw

Why the great credit freeze of 2008 won't turn into the Great Depression of 2009.

(Money Magazine) -- Well, we were partly right. At this time last year, we said that the stock market would be increasingly volatile in 2008, that home prices would fall further and that a subprime blowup could propel the economy downward.

But not in our wildest dreams did we foresee anything like the kind of jaw-dropping, stomach-churning ride that lay ahead. The economy in recession (as most experts now believe)? The Dow off 40%? Credit markets frozen worse than Sarah Palin's hometown? Precious few saw all that coming.

Peering into the future is tricky in the best of times. But even though predictions always turn out to be flawed - it's impossible for even the smartest experts to nail this stuff perfectly - you cannot build a future without first guessing what challenges you'll face on the way there.
History is your best guide. It has taught us that recessions tend to push inflation lower; that stocks usually recover before the economy does; and that jobs recover later. Most of all, history shows us that downturns don't last forever - and that it's when people are most disheartened that rebounds begin.

THE ECONOMY
The prediction: The recovery will begin in the second quarter of the year.
As 2008 draws to a close, fears of a recession seem almost quaint. For many people spooked by the vicious credit crisis and the 2008 stock market meltdown, the real fear now is the D-word. Six in 10 Americans believe a depression is somewhat or very likely, according to a recent poll by CNN/Opinion Research Corporation.

Take a deep breath, people. The catastrophic 10% annual decline in economic output that marks a depression is simply not going to happen, according to even the most pessimistic mainstream economic forecasters. The gloomiest of the bunch aren't calling for anything remotely close to the crushing 25% unemployment rate seen during the Great Depression that began in 1929.

That's partly because back in the days when people were cooking up bathtub gin, the unprecedented actions taken by the U.S. and European governments this past fall to help stabilize the global financial system weren't even imaginable.

Still, few of us will feel like popping champagne corks in 2009. The consensus among nearly 50 economists polled each month by Blue Chip Economic Indicators is that a recession (officially defined as two or more consecutive quarters of declining gross domestic product) started in July and will continue throughout the first three months of 2009 (see the chart to the right).

The economists estimate that the economy - staggering under the credit crunch and one of the worst housing busts this nation has ever seen - will continue to shrink by 0.1% in the first quarter. It will then start growing again, but sluggishly. GDP growth is forecast to hit about 2.5% by the end of 2009, below the U.S. economy's long-term annual growth rate of about 3%.

But this recession, even if it's relatively short and shallow, is likely to leave you feeling queasy for quite some time after it's officially over. One reason: The unemployment rate is expected to keep rising throughout 2009, to 7% by the end of the year (see the chart). Many other economists think it could top 8%.

"If you define recession by GDP, it could be over by the spring," says Maury Harris, chief U.S. economist at UBS. "If you define it instead by the unemployment rate, which tells you a lot more about how people are feeling, you'll probably have to wait until 2010 for things to start improving."

To be sure, the U.S. government has been pulling out all the stops to alleviate the credit crisis, including a massive injection of capital into the troubled financial system.

But it's not just banks that need cash. Thanks to the bursting of the housing bubble, consumers can no longer borrow against their homes with abandon. Because consumer spending represents 71% of gross domestic product, any reduction in it could be a big drag on the economy.

Meanwhile, home prices are set to fall further. "You can throw every policy you want at the housing market, but you can't stop the fundamental price correction that is still required to offset the speculative excesses of the bubble," says Jared Bernstein, a senior economist at the Economic Policy Institute.

Add the cost of the bailout to the record $455 billion federal deficit (some economists think the deficit could reach close to $1 trillion in 2009) and you can expect still more pain - in the form of higher taxes to pay for it all.

"I don't care who gets elected in November," says Barry Ritholtz, CEO of research firm Fusion IQ. "Your taxes are going up."

THE WILD CARD
The mideast tensions over Iran's nuclear program are already mounting. If there's a military flare-up in the region, the price of oil - about $65 a barrel at press time, down from a record high of $147 in mid-July - could skyrocket again, sending the U.S. economy into a much longer and deeper recession.

THE ACTION PLAN
Keep your eye on three key signs that the overall economic picture is improving. These clues can help you decide when to make moves you may have put on ice for now, such as starting a business or moving to a bigger home.

Check the three-month TED spread
It's the difference between the interest rate at which banks borrow from one another (known as Libor) and the rate on three-month T-bills. The wider the spread, the more skittish banks are about lending. It's now just under 3%, far above historical levels; when it drops below 1% you'll know the credit market is almost back to normal.

Where to find it: Go to Bankrate.com, search for the three-month Libor rate and the three-month T-bill rate, and then subtract the T-bill rate from Libor.

Track real estate inventory
Historically, the number of months' worth of inventory on the market has reliably predicted home prices. Six months of inventory appears to be the sweet spot for a healthy market; right now it's 10 months. The National Association of Realtors puts out the inventory data each month, usually between the 22nd and the 25th.

Where to find it: Go to the Research section of realtor.org.

Watch initial jobless claims
The number of new people filing for unemployment benefits, released every Thursday morning by the Labor Department, has been running between 450,000 and 500,000 a week lately.

"When you see those numbers start to come down below 400,000, that'll be a very good sign that the worst of the pain is over," says Brian Wesbury, chief economist at First Trust Advisors.

Where to find it: Do a search for jobless claims on our Web site

By Janice Revell, Money Magazine senior writer
Last Updated: November 4, 2008: 2:28 PM ET