This is the first post here concerned only with forecasting. As such, it is labeled "forecast" at the end of the post. If you're interested in the theory underlying the forecasts, read the seven initial posts labeled "priority."
NBER Declares a New Recession
Yesterday, the National Bureau of Economic Research stated that economic activity peaked in December of 2007 and that we then entered a recession. I refer readers back to the following statement on my post of October 10, 2008:
Note how the consumer expenditures in the GDP figures have started to be revised downward all the way back to the fourth quarter of 2007, revisions that are completely consistent with a monetary contraction beginning around the second quarter of 2007. Note also the reversal of the commodity bubbles around the world, the continuing fall in housing prices, and the steady rise in the stock market came to an end by the third quarter of 2007. All of this is consistent with a monetary contraction beginning in the second quarter of 2007, as explained in the monograph.
Finally, note the carnage in the stock market, the contraction of global credit and the sudden strengthening in the dollar over the past several weeks as the world's investors come to grips with the reality that we are deflating, rather than inflating.
While it was obvious that we were already in recession when I wrote the above in October, what was not obvious was that the recession started at the beginning of the year. In fact, there was very little talk of a recession until mid-year and even then the majority of forecasters seemed to be hoping that the travails of the housing market would be overcome by strong international activity.
The Proverbial Water Over the Dam
I bring up the past "forecast" (which I never made on a timely basis in a public forum and therefore it can hardly be called a forecast) merely to illustrate that the theory I set forth in the seven priority posts correctly fit the past activity. In that sense, it does little good. It is indeed water over the dam.
What should be learned by those of you reading these posts is that the bulk of public opinion during the past two years alleging that the Fed was being too easy was wrong. In fact, the Fed was being far too restrictive. Again, you really do need to read the monograph referred to in the earlier posts, and dissect those posts carefully if you are to understand the underlying mechanism that drives my conclusions.
Implications for the Future
What now? Given the massive injection of reserves into the system, many economists would naturally wonder whether the Fed has successfully eased. However, they remain concerned that the Fed is merely "pushing on a string" and that the injected reserves will remain unused. This is not the case, however, because demand deposits skyrocketed at an historic rate as soon as the reserve injection was initiated.
Under past operating procedures, this would always have happened due to the "hot potato" theory of monetary policy that I've explained in the monograph. Now, however, those operating procedures have changed and it becomes much more important to determine whether the Fed is indeed "pushing on a string." Right now, it appears they are not, because demand deposits have grown apace. They will bear close watching over the next several months though, to ensure that the present levels are sustained.
The Economy
With the demand deposit burst occurring in September of 2008, it is reasonably certain that the economy will begin to rebound soon and that by March of 2009 (exactly six months after the money burst) signs of that rebound will have become evident. These signs will include accelerating retail sales, durable goods orders and finally employment numbers. If the past is any guide, the first signs will be complete surprises to market participants, will temporarily move markets, but will then be overwhelmed by other (lagging) published information. Typically, the statistic that finally convinces the doubters, who will be legion to the very end, will be the employment number. Even then, it will take as long as two or even three quarters of recovery before the NBER declares the end of the recession.
The Bond Market
Again, if the past is any guide, interest rates will fall until the first signs of a recovery and then will begin a rapid rise that will be sustained for a long period. The caveat to this forecast is that interest rates, particularly on longer maturity treasuries, are already at ridiculously low levels that might not be sustainable for another three to four months. The carnage in the bond markets in the second quarter of 2009, if present rates hold until then, will be something to behold.
The Stock Market
I've found that the stock market reacts rapidly to a change in demand deposits, so by March of 2009 we will likely have experienced a significant recovery in stock prices. The Fed was executing an extremely tight, even deflationary, policy until the third week of September after which the sudden increase in demand deposits occurred in response to the massive injection of reserves. Unfortunately, by that time the stock market had already started its severe decline, a decline which essentially was wrung out by the second week of October. Presently the market is trying to put in a bottom around current levels, an effort that should prove successful.
The Housing Market
This is a market that got about 80-100% too high relative to general prices and it did so in a near-deflationary environment besides. The implications are that the rise was the result of a herd mentality (assisted by the nearly-insane lending standards fostered upon the industry by Congress--let's put the blame where it really belongs here) and that to reach equilibrium housing must fall, relative to other prices, by 40 to 50% over the next few years. In other words, no near-term recovery in housing is likely and, in fact, housing prospects are likely to continue to deteriorate. The only possible way to forestall this is to induce a sharp, sudden inflation.
The Inflation Picture
Which brings us to inflation. If the present burst in the money supply is sustained, then inflation will indeed reassert itself. However, since the Fed has effectively relinquished most of the power it once had over the level of the money supply with its recent (and accelerated) change in treatment of excess reserves (See the previous post for an explanation,) it is anything but clear what present policy will yield. If you understand the content of the priority posts on this website, they you will realize that just because the Fed tries to effect an easing in policy doesn't mean that they will be successful, even if it appears that they are. After all, Japanese authorities tried for years to ease following their real estate and stock market debacles of the 1980's and yet remained mired in a ten-year deflationary environment.
Right now, though, it would appear that the Fed is finally managing to reflate, and on a grand scale at that. This could turn on a dime, however, and bears watching.
A Word to Business Leaders
Would it have been useful to know in the fourth quarter of 2007 that the risks of an imminent recession had grown substantially? Look at your own forecasts at that time and decide. Now examine your present forecasts and ask yourself if it would be useful to learn that the economy will begin accelerating soon and that the recession should be behind us by the second quarter of 2009? I'm reasonably certain that this will be the case and that you should be making plans on that basis unless you are depending upon a recovery in the housing market as well.
You've got real money on the line, so if this economic forecast proves accurate, you might even want to consider adding me to your list of consultants. Have the ones you've been relying upon been doing all that well recently?
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