Lots of kindling

Are we headed towards a recession in 2007? Housing markets have begun to turn, interest rates are back where they were pre-9/11 and oil is near $80 a barrel. Nouriel Roubini puts the risk of a US recession at 50% for 2007. I like this approach – no one can predict the future so we must think ahead in terms of probabilities.

Here’s an excerpt:

It is hard to predict with certainty whether the U.S. and global economy will suffer of serious stagflation or even a recession. … I have recently argued that the probability of a US recession in 2007 is, in my view, as high as 50%. In brief, the Three  Bears of high oil prices, rising inflation leading to higher policy rates, and a slumping housing markets will derail the Goldilocks (of high growth and low inflation) and trigger a sharp U.S. slowdown in 2006, that may turn into a recession in 2007.

Fed Chairman Bernanke is downplaying the risks of a recessions but many out there are starting to worry about it a lot. The Fed may also want to learn from its previous serious forecasting mistakes. In 2000, it took six months for the U.S. to go from overheating into outright recession: in Q2 of 2000 the economy was growing at an annualized rate of over 5% and it slowed down to close to 0% by Q4 and entered into an outright recession by Q1 of 2001. As late as September 2000, Fed discussions – see their Minutes – were showing the FOMC being mostly clueless about the upcoming recession and still worrying more about the alleged rising inflation (with their view of the balance of risks stressing rising inflation rather than slowing growth). It then took a suprising and lousy Chrismas season of sales and a crashing Nasdaq at the beginning of the new year session on January 2nd 2001 to get the Fed into reality check, panic mode and start reducing the Fed Funds rate at an exceptional inter-FOMC meeting point.

And in 2000, the triggers for the recession were suprisingly similar to 2006: then a tech sector investment bust (now a real estate sector bust); then a Fed tigthening of 175bps (between June 1999 and June 2000), now a 425bps (soon 450bps) tigthening; then a modest oil shock (with oil rising from low teens to high teens in 2000 on the basis of Mid-East tensions and the beginning of the second intifada), now oil rising from $ 20 to 40 to 60 to 75 (and soon enough to 80) on the wave of much more serious Mid-East tensions (Israel conflict with Palestinians and Lebanon, growing security mess in Iraq, rising risks of a confrontation with Iran on the nuclear proliferation issue); then, there were worries – mostly unfounded in reality – on the risks of rising inflation, while now there are much more serious real worries (in spite of Bernanke’s latest flip-flop on the issue, to cite Steve Roach today) on a truly rising inflation rate (see also WSJ’s Greg Ip on Bernanke keep on saying one thing and doing another for the last few months; so much for Fed transparency and consistency of its communication strategy).

So, why does Bernanke believe that a “U.S. recession is not likely?” Why are things better now than in 2000 when all indicators show similar vulnerabilities but only more severe and scary ones now than in 2000? There are much more severe vulnerabilities now compared to 2000-2001 as today:

  • the U.S. consumer is facing negative savings, rising debt and debt-servicing ratios; is being buffeted by rising rates, rising oil, slumping housing, rising inflation; is experiencing falling real wages and rising inequality thas is slumping aggregate demand. Thus, the US consumer is in much much worse shape than in 2000.
  • When the tech bust led to the  2001 recession, the recession was much more shallow than could have otherwise been as the  U.S. consumer – then strong after a decade of rising real wages and falling income inequality – was very resilient and kept on spending while corporate investment slumped. Thus, the recession was modest and short-lived. This time around the battered U.S. consumer and worker is not resilient at all.
  • Compared to 2000 when the current account deficit was small (and driven by the 1990s investment boom) while fiscal policy was sound (a huge surplus), today the U.S. economy is much weaker with a huge twin fiscal and current account deficit and a structural fiscal deficit.
  • Compared to the post-2001 recession, when the Fed could slash rates from 6.5% all the way down to 1% and Treasury went to a reckless fiscal stimulus (turning a 2.5% of GDP fiscal surplus into a 3.5% deficit), today the levers for policy easing are much more limited. Indeed, given the inflation pressures, the Fed may have to keep on tigthening or at most pause and cannot afford to slash rates. Moreover, the fiscal deficit is such a structural mess that the idea of using fiscal drug stimulus to counter a recession would be outright reckless.

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