Confessions of a Flawed Forecaster
Three economic scenarios were possible after the stock market crashed in October. I thought that there was a 50% chance a moderate recession would come in the near future. This was based on the likelihood that the market collapse would dampen purchases and drive nearly everyone, particularly consumers, into a more liquid position--cutting back on debt and riskier assets.
Then there was the “hiccup-pickup” scenario. This was the theory that the crash would inhibit spending only temporarily. After a brief hiccup in the form of a minor inventory adjustment, the economy would pick up momentum--to the point of stress, fueling accelerating wage and price inflation, rising interest rates, a renewed fall in the U.S. dollar and, eventually, recession. I gave this a 30% probability.
Finally, there was the “muddle-through” possibility, a politician’s dream. The economy would move along at a pace fast enough to keep employment and income growing slightly and the unemployment rate steady. At the same time, the pace would be slow enough to prevent price pressures from seeping into the general wage and price system, thus avoiding any need to tighten monetary policy or increase interest rates.
In other words, the economy would stay out of sight as a negative political issue. With the financial world inclined to lunge toward extremes, such a tame prospect struck me as highly unlikely, so I gave it only a 20% chance.
Downward Pressure Relieved
In retrospect, not much happened as a result of the crash, or so it would seem. Consumer spending did weaken and, for that matter, remains soft. Consumer inclination to incur further debt was dampened but not enough to kill the credit-dependent auto market; indeed, it would appear that much of the excess in auto inventories already has been worked off without much distress.
Also, exports appear to have expanded rapidly, relieving some of the downward pressure from weaker domestic demand.
Most important was the apparent speed and skill with which U.S. monetary policy was flipped from progressive tightening before the crash to fairly massive easing in the days thereafter. That probably had more to do with buffering the economy from greater damage than all other policy actions combined.
A major shift in liquidity preference is nearly impossible to measure and therefore very difficult to counteract through changes in monetary policy.
One of the key reasons for the severity of the 1929-33 depression was an inability of the Federal Reserve to comprehend the magnitude of the shifting demand for liquidity, compounded as it was by massive bank failures.
This time, however, the Federal Reserve seems to have gauged things fairly well, placing the right amount of liquidity in the system at just the right time and then (apparently) withdrawing some of it as the crisis eased.
But all this presupposes that the October crash is all there is to this bear market. Unfortunately, the continued skittish behavior of the financial markets belies the surface calm of the world’s real economies, suggesting that all may not be well, that there may be another shoe to drop.
Indeed, bear markets almost never before have been disposed of simply or very fast. October’s news reinforced consumer preferences for liquidity just as they were beginning to wane.
But if that’s all there is from the recent financial disruption, if it was just a computer-driven anomaly, then the desire for greater liquidity will dissipate and the recently acquired liquidity gradually will be spent. Consumers once again will start to load up on debt and the U.S. economy will expand at an accelerating pace--for a short while.
The huge employment gains of recent months suggest that we’re heading toward the hiccup-pickup scenario.
Accordingly, it would seem appropriate to boost the probability of that scenario from 30% to 50%, while reducing the probability of imminent recession to 30%.
Even 30% may seem ridiculously high to some observers, given the ebullient conditions of the moment. But there remain several serious and unresolved questions regarding the direction of both the real and financial economies.
Among the questions: What should we conclude when retail sales remain quite weak while production continues strong? The suggestion is that, other than for autos, inventories elsewhere in the country continue to build and may be reaching hefty levels as we enter the second quarter. It is still possible that we are developing excessive inventories and don’t realize it yet, a la 1974.
Another question: What if 40% of the large reported gains in employment since last December just don’t square with other evidence?
The largest employment gains came in the construction and retail trade sectors, both of which have been distinctly weak in terms of sales, orders, permits, etc. If the employment gains are ephemeral, we may be bitterly disappointed in coming months.
Uncork Wage Inflation?
There also is the issue of the ability of world financial markets and economies to shrug off new shocks that may evolve from stronger-than-expected business conditions.
For example, we cannot have strong domestic demand in the United States and still have declining imports and expanding exports. How will the financial markets react when the trade deficit stops improving?
On another front: How much further can we push up the utilization rate of both labor and machines before we uncork wage and price inflation by renewed domestic wage and price inflation?
If that happens, what can we expect from long-term interest rates? How will the equity markets react if interest rates rise?
How will the foreign exchange markets react if they don’t? Are the markets buoyant enough to deal with these potential problems?
OK, so maybe a 50% probability of recession was a bit on the high side. Funny thing, though, cutting it to 30% doesn’t make me feel any less uncomfortable. I still walk hunched over, waiting for that other shoe to drop.
