Monday, May 4, 2009

Three forecasts and a funeral

Forecasts: the accepted, the shunned and the feared

The 'Consensus' or accepted forecast: The 'consensus' forecast is a gradual return of GDP growth to positive territory. The consensus forecast does not kick the economy into gear quickly and the growth rates for GDP remain low for some time. The rate of unemployment will continue to rise in this scenario well into the recovery as it did in the 1990 and 2001 recovery periods. The consensus forecast is an odd bird: it grafts the reality of a deep, long, recession onto the fantasy of a weak drawn out recovery a combination we have never seen. The consensus pretends that recessions like 1973-75 and 1981-82 could have produced recoveries like those for the 1990 and 2001 recessions. Frankly I doubt it. 

My forecast, the shunned forecast: My forecasts is considered by some to be a Pollyanna forecast but more rightly it could be construed as the risk forecast. What I foresee is a much faster rebound in GDP growth than the consensus. This rebound nets us roughly 4.5% growth in the first four quarters of economic recovery. That would make it a relatively strong recovery unlike the consensus and one that will contain the rise in the rate of unemployment within one of two months of recovery. If I am right there will be no drawn out recovery in the labor market. While it might not be a full recovery, it will be an immediate recovery. If this forecast comes to pass the rise in the rate of unemployment will come to an end quickly, early in the recovery period as GDP growth snaps back and hiring kicks back in after an overshoot of layoffs. This forecast seems to be one that takes us immediately to Nirvana but it may not. It is only good news if, after the strong phase of recovery (about the first year after recession ends) the economy can sustain its growth and keep from backsliding into recession. Yet this strong-start recovery puts that very event at risk

The feared disaster forecast:  While some will construe my forecast as the Pollyanna forecast it is in fact a riskier forecast than the consensus. Here is the risk: It’s that strong growth early in the recovery will prod the Fed into early action.  Many are concerned already in the presence of the consensus forecast with how the Fed will unwind its policy of extreme accommodation. The consensus forecast is for the economy to remain weak; in such a scenario the Fed will be able gradually to take back its stimulus as economic improvement gradually occurs.  But in my forecast everything happens fast. The economy jumps into recovery and job growth kicks back into gear early as the unemployment rate stops rising and begins to head lower. While the economy will not be entirely mended at this early point of recovery the strong growth will put the Fed on the spot.  The rapid growth will put maximum pressure on the Fed to begin to pull back in some of its stimulus including shrinking its balance sheet and hiking rates as well as to eliminate some of its special programs. It will make Congress skeptical that any added assistance is needed.  Yet the economy will not have solved all its structural problems at that point of recovery. The risk is that the Fed could pull back too soon and the structural problems could re-emerge form the background causing the economy to plunge into a second dip of recession.  It's the economy's funeral that is threatened.

We know where the risks lie even so... Policymakers have said that the risk in challenged times such as these is to keep stimulus in place long enough. We know that monetarists are already screaming for the Fed’s head and for a road map of the end game that will result in the stimulus being removed. We know the Fed will be under great pressure to act once the recession is over. We know that there is nothing like a few quarters of growth of 3% to 4% to say that recession is over. Yet we also know that a few quarters of strong growth like that will not heal all the wounds of the recession so that despite a few strong quarters the economy will not be fully healed. 

Where the real risk lies - We continue to think that is where the real risk lies in this recovery period despite our projection of a strong economic growth recovery. The risk will be in the potential to backslide.    The Fed is still talking about the risk of deflation and no one really believes it. As the Fed mounts campaigns to buy Treasury paper and knock long term rates lower treasury rates instead have been in a steady rise and rates have gone up above the 3% mark for 10-year notes, attesting to the impotence of the Fed on this matter.   

Why that recovery forecast?  - The strong growth scenario will be the hardest one for the Fed to deal with. An easy growth recovery would keep the Fed in a gradual back-off from its special programs and actions. But as we look back at history the strong growth scenario is the most likely since we have never seen the other. Deep long recessions never have produced weak drawn-out recoveries of the kind the market now says it foresees from this deep dark recession. I can understand the Fed offering such a forecast since it would be hard for the Fed to be forecasting such a rosy scenario and still offering all this assistance to the markets. If the Fed projected a jackrabbit recovery many would be on its back to right now start shrinking its balance sheet in anticipation of it. I think the Fed forecast is purposely naive. 

Beware the recovery -- We have seen a too-fast recovery run amok. A jackrabbit start to recovery from the 1980 recession brought a too-quick and too-high Fed tightening reaction that took the economy from a brief deep recession into a fast but truncated recovery and to a new deeper darker recession. So we have seen that happen before. Even if my forecast for recovery is correct this episode will be different from that one since the Fed does not have monetary policy on auto-pilot as it did in the 1980s. But the risk is the same, the risk of a central banking reaction mistake. In 1981 the Fed reacted to a too-strong recovery and a still too-high inflation rate; its overreaction gave us the double-dip recession. In 2009 the risk will be from an underlying economy that is weaker than the fast recovery will make it appear to be. The risk will be the risk of a Fed that is already worried about how much it has done stopping too soon. It will be the risk pushed onto the Fed by critics ideologically opposed to the assistance that the Fed already has provided.  So beware of the recovery. In it lurk perhaps even more risks than in recession itself. Because while recessions are renown for their danger few stand vigil against the failed recovery.  And who would expect such a fast recovery to be the first step on the road to economic perdition?

1 comment:

Uchenna said...

Dear Sir,
I found the piece entitled "Three forecasts and a funeral" particularly illuminating not merely because of your distinct views which appear to fall outside the present "(market/academic) consensus" of macroeconomic forecasting but precisely because your views seem supported by historic recessions of the 20th century.
If I may venture a couple queries, 1) Why do you think that the present "consensus" expects a protracted recovery; and 2) Why do you believe the real expectations of the Fed are being kept close to the vest?
Best regards,