While the mortgage credit losses still don’t look huge relative to the size of the economy or the financial markets — the baseline assumption in the paper is $400 billion in losses, which is about 2-1/2% of total equity market cap or “just one bad day in the market” — they are nevertheless responsible for much of the financial and economic turmoil of the past 6 months. It is estimated that roughly half of the total losses are likely to be borne by leveraged US financial institutions, which aggressively mark to market and closely monitor their leverage and value at risk.

Assuming that these institutions will aim to lower their leverage by 5%, the baseline estimate is that they will scale back their lending by close to $2 trillion in response to these losses, even if we assume that they manage to “replace” 50% of the lost equity via inflows of unlevered capital, e.g. from sovereign wealth funds. Further, it’s estimated that just under $1 trn of this credit supply hit is a “Main Street” event and will hit unlevered entities such as households and nonfinancial businesses; the remainder is a “Wall Street” event and will hit other leveraged institutions. Finally, it’s estimated that the credit supply hit could shave 1-1½ points from real GDP growth over the next year, over and above the “traditional” hit from reduced homebuilding demand, a negative wealth/MEW effect on consumer spending, and the multiplier effects working via the labor market.

Recession signs continue to multiply. While the Philly Fed and the Chicago PMI — the two non-ISM industrial indicators with the longest history — are rather noisy, it’s noticeable that both are now at levels that have never occurred outside the immediate vicinity of an overall recession. Moreover, the labor market is now clearly giving way, with the biggest month-to-month decline since 2001 in the “jobs plentiful/hard to get” differential in the consumer confidence survey and a surge in both initial and continuing jobless claims in recent weeks. More data along these lines will soon persuade most forecasters to adopt a recession view (currently, there is still a slim majority in favor of the no-recession view).

So what about the Fed? Fed easing will last for a long time and FOMC will not quickly take back the easing moves. Renewed tightening is unlikely until a) house prices bottom and b) the unemployment rate peaks. Since neither will happen until late 2009, so don’t expect any rate hikes before 2010.