January 14, 2009
RECESSIONS, BUSINESS CYCLES AND LOOKING FORWARD
Forecasting cyclical turning points in the economy (and inflation) is job one at the Economic Cycle Research Institute (ECRI), a New York consultancy. In fact, it seems to do so rather well, or at least it has in the past. Notably, ECRI has earned some well-deserved praise in recent years for correctly predicting the 2001 recession.
But the current downturn has been a little trickier. True, ECRI was warning of trouble in late-2007. Even so, the firm held out hope that a recession might be sidestepped. As discussed in a November 2007 report, ECRI explained that "the leading indexes are not yet in a recessionary configuration, thus a recession can still be avoided." Alas, it was not to be. With the clarity of hindsight, we know that the recession began in December 2007, as per NBER's official (albeit 12-month lagged) dating of the downturn's start.
To be fair, ECRI was advising that a downturn was possible well ahead of December 2007. Today, the firm counsels that the recession is well entrenched and that economic contraction looks set to roll on. "The bad news is that the recession is going to continue for the next couple of quarters, and we know that objectively from the leading indexes," says Lakshman Achuthan, managing director of ECRI and co-author of Beating the Business Cycle: How to Predict and Profit from Turning Points in the Economy.
In an interview earlier today with The Capital Spectator, Lakshman talked of recessions, how we got into this mess and the outlook for, one day, better times. If you have a taste for the ugly details of the business cycle, read on…
Lakshman, ECRI did a nice job of predicting the 2001 recession. Were you ahead of the curve this time?
No, we were much more coincident, for a whole host of reasons. We said a recession was unavoidable in early March 2008. The reason we held out some hope that the recession could be forestalled was because of a weird confluence of events going on at the end of 2007 and early 2008 with respect to inventories—manufacturing stuff in the U.S. economy.
Typically recessions are kick started in many examples by a big inventory overhang that, all of a sudden, in sort of a Wile E. Coyote moment, give way and the floor falls out from under manufacturers. They realize that they have way too much inventory and they stop [producing]. That's how a lot of recessions tend to start.
But not this time.
No, it didn't happen that way. There was very little inventory and so we didn't have that kind of downturn in the economy. That gave policymakers the briefest window of opportunity to maybe push [the recession] off. But they weren't that worried and thought they had things pretty much under control. And we had growth abroad that was still drawing on U.S. manufacturers and so there was a widely held belief that we didn't have to worry about [recession] and that we were managing the home price decline and the emerging credit crunch quite well.
The economic cycle has in fact been some sending false signals, or certainly misleading signals in recent years, or so it seems. Inflation, for example, was running hot in the first half of 2008. But by the end of the year, deflation seemed to be the big threat.
Yes, it's been very schizophrenic. For example, the assumption in many models was that home prices couldn't go down; now the assumption is that they can't go up. All along the way there were plenty of prognosticators saying extreme things. Today there are some expecting a depression while others are expecting things to rebound in the second half of this year.
Looking back, you can see how this recession was set up. Certainly oil was part of the reason. We started to have oil spikes in 2005, and every year since then, through early 2008, we had oil spikes. Every time you had an oil price spike, someone warned of recession. When you had the housing market downturn begin in 2005, and you combine that with an oil spike, a lot of people saw recession.
But those were false signals, at least for a few years after 2005.
Right, and instead what we saw was that the economy accelerated to a four-year high with the growth rate in 2007. That's kind of an inconvenient fact. We actually grew faster than Europe in 2007. This wreaked havoc with all kinds of assumptions that decision makers had taken. In fact, the acceleration in 2007 may have lit the match for a lot of this credit stuff.
Because decision makers in the fixed-income markets and other markets were looking for a recession in 2007, but it never happened. You had the expectation on Wall Street, at Merrill Lynch and Goldman Sachs, for instance, of a 75-to-100 basis point rate cut by the Fed. And then one day in early June those two houses, which have a lot of followers, abruptly turned on a dime and said they didn't think there would be any rate cuts in 2007. What this did was immediately wreak havoc with all of the models pricing subprime credit groups, where the assumption was that rates would go down and so those instruments would maintain their credit ratings. The minute you took out the rate cuts, the guise fell away and everyone started running away from subprime debt very quickly. And that continues today.
So you had a housing price downturn that began in 2006 and then morphed into a credit crunch in 2007. These are massive things that take time to resolve. But they don't in and of themselves mean that you must have a recession. Our indicators were saying, yeah, things were bad, but it wasn't a guaranteed recession.
When did things take a turn for the worse in terms of triggering a real economic contraction?
We started to get a real recession risk in the second half of 2007. Our weekly leading index peaked in June 2007, about six months before the recession actually began in December 2007. In fact, by December 2007, our weekly leading index had plunged to its worst reading since the 2001 recession. However, because of these inventory issues I mentioned [there was an expectation that] maybe we would be able to buy a little bit of breathing room. That didn't happen. You saw the recession begin at the end of 2007. All the dead bodies started showing up in 2008 as the recession turbocharged the housing downturn and credit crisis.
What's the outlook now?
The outlook remains recession. Retail sales, the Fed Beige Books, industrial production, jobs growth—these are all coincident indicators and they confirm that we're in the most severe recession in the post-World War II era. This was forecast by our weekly leading indicators. Our leading index had earlier fallen to a 60-year low. So it's not a surprise that the coincident indicators are now weak.
What has changed in very recent weeks is that the leading indicators have begun to stabilize. I'm not suggesting that there's an imminent recovery ahead, but it is notable that we've gone from minus 30% growth rates to minus 25%, minus 28% or so. I suspect this is largely related to hope. We have a new year. We also have a new administration and some new stewards of the economy. There's talk of a new stimulus plan. The leading index may be showing there's some pause to this sharp decline. However, an objective reading of the index doesn't yet show a sustained recovery. That would require a very persistent and pronounced rise in the leading index for us to make that kind of forecast. What we know objectively is that the first two quarters of 2009 are going to be recession quarters.
The longest previous recessions were 16 months each, in the early 1970s and early 1980s.
If we date the current recession's start to December 2007, that suggests that we'll soon match the previous recessions' 16-month time frames. Does that mean we'll be getting close to the end of the current downturn later this year?
Saying at this point that the recession will end in the second half is really a coin toss—no one really knows. We don't know because the leading indicators haven't turned up yet. The bad news is that the recession is going to continue for the next couple of quarters, and we know that objectively from the leading indexes. The good news is that the leading indexes can't see that far. A lot of it is going to depend on, for example, the stimulus debate. If the stimulus is three times the proposed size and it happens quickly, then that's one extreme and so there's probably a chance of some kind of bump in the second half of 2009. On the other hand, if the stimulus is delayed, or adjusted down, maybe there's less chance.
Keep in mind that the recessions of the early 1970s and early 1980s were also international recessions. The number of countries in recession around the world today is the broadest we've seen since World War II. It's broader now than it was in the 1970s and 1980s in terms of the diffusion and pervasiveness of the recessions globally. That informs our view of what may happen in the U.S. There's a linkage: The broader the recession, very often the longer it is.
Posted by jp at January 14, 2009 1:43 PM
Good article. One of the few objective institutions.
Posted by: Kjell at January 15, 2009 1:34 PM
That closing line bugs me -- I can't see any economy pulling out of this before the U.S. so we really need to see a recovery here soon.
Posted by: Cindy at January 14, 2009 7:59 PM
This is pretty cool. I'd like to hear more about recovery, sounds I will have to stay to the side and wait. Great coverage, keep it up.
Posted by: Brad at January 14, 2009 3:36 PM
Hard to find more than soundbites from ECRI and I do like following their work. Thanks. Here are more links related to their recession call this time around.
Jan '08: http://kirklindstrom.blogspot.com/2008/01/ecri-says-there-is-window-of.html
Mar '08: http://kirklindstrom.blogspot.com/2008/03/ecri-calls-it-recession-of-choice.html
Posted by: Owen B. at January 14, 2009 3:20 PM