Disclaimer - All economic projections and forecasts should be treated with extreme skepticism. Generally speaking, we are very good at projecting the future so long as current trends continue. However, we are very bad at projecting turning points which are exactly the times when you really want to know. In fact, if you take the consensus forecasts to be found in the popular press they are usually little more than extrapolations of current trends.

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February 28, 2009 Update

In a presentation at the end of February I noted that the predictions made in December were still pretty accurate but that we were likely to be looking at the bottom end of that range. As expected, 4th quarter growth was very low and preliminary readings on retail sales, unemployment and other indicators show further very bad news with still more likely to be on the way.

The prediction of at least 8% unemployment came true today (March 6) with the further prediction of 9 or even 10% not being out of the question still looking accurate. As predicted, housing prices have continued to drop like a rock and commercial real estate is indeed following suit. However, the less securitized nature of commercial mortgages together with their smaller total (a bit under 25% the amounts in residential real estate) means that the negative shock from this decline won't be as big as that from residential real estate.

The stimulus plan as passed by Congress is good, but too small in and of itself to do what is needed. At a bit less than $400 billion each for this year and next it amounts to a bit less than 3% of GDP, well under what most observers (at least those who believe in the concept of a stimulus) would think is needed. As a benchmark it should be noted that deficits as a percentage of GDP peaked at around 25% during World War II and while that might well be excessive at the present time it is obvious that there is plenty of room for a bigger stimulus.

Fortunately, the President's budget proposal provides just that. If passed more or less as proposed, it would provide a jolt of a bit more than 10% of GDP, which is in the range of what is needed at this point.

Less clear, however, is the adequacy of the proposals for rescuing the banking sector. Most of the proposals floated by the Administration so far revolve around buying (or inducing the private sector to buy) the toxic mortgage assets from the banks. The problems with this are many, among them

- There is presently not much of a market in these securities and hence no good idea of a market price

- It is hard to imagine any private sector entity actually wanting these assets at a price that would leave the banks solvent. Either they pay too much and save the banks at their own expense or they pay too little and don't solve the basic problem of insolvency that the banks are facing.

- Efforts to pump up the prices of these assets are unlikely to succeed. They may well be worth more than what the market is discounting at present, but we wont know that for quite some time to come - That is, the only way the mortgage backed assets are worth as much as we would like them to be in a rosy scenario is if the stimulus and financial rescue packages are successful at restarting growth and therefore reducing foreclosures. Apart from the obvious chicken-egg problem in this, even under good circumstances it wont work out for several years - and we dont want zombie banks staggering along for that long.

What to do? I believe the inevitable will have to be faced at some point this year and the sooner the better. The larger zombie banks deemed too big to fail (Citi, BofA, etc.) need to be taken over, stripped of their toxic assets, recapitalized and sold back to the private sector. The virtues of this are that the banks would quickly be relaunched without a question mark hanging over their long term survival, and the government could recoup a large part of the cost of eating the bad assets and recapitalization from the proceeds of the sale, Furthermore, it would avoid the problem of using tax dollars to bail out bankers and stockholders who have gained massively from the profitable years of the mortgage bubble, but are so far escaping the usual consequences of making decisions that result in bankruptcy. Going forward it is very important that decionmakers think twice and three times before doing things that put not only their own institutions, but the whole financial system at risk.

In terms of growth, we are still on track for the pessimistic end of Decembers predictions of 2% decline but worse if the stimulus package is too small (so far it is) or if the banking crisis is not resolved (which so far it isnt).

The dollar continues in the range it was in last December (in the high 1.20's against the euro) and it is still hard to see it strengthening further from this point, though some amount of weakening is not unlikely at some point when the current flight to Treasury assets abates.

The powerpoint presentation for this talk can be found here..

Predictions for 2009

I predicted last year that 2008 would be a slow growth year in the range of 1-2% "unless the credit crunch gets ugly" in which case it would be lower. This has proved true with growth through the third quarter in the 1-2% range and clearly set to be lower in the fourth quarter as the economy moves into recession.

There is no doubt that the popping of the housing market bubble and consequent collapse of the credit markets built on the basis of various types of mortgage backed assets and derivatives has spread well beyond real estate by now. Nevertheless, we have yet to see the bottom of the real estate market: Housing prices still have not fallen into normal historical ranges of ratios such a home prices to income or prices to rent while commercial real estate is only now starting to decline. The continuation of this into next year will provide further downward impetus as the economy contracts.

Credit markets remain frozen up as paranoia runs rampant through the banking industry and individual banks work hard to restore their balance sheets to a stronger position. Given the reluctance of banks to lend and of customers to borrow it will be some time before normalcy returns.

Consumers have at long last realized how overextended they are and household debt ratios have declined for the first time in a long while. This retrenchment means very weak Christmas season sales and with stagnating or declining personal incomes coupled with there is no reason to think that consumers can be the engine of recovery Industrial production has started downward as well, largely in response to declining demand, making it extremely hard to forecast any recovery of business investment in the near future.

Given the fact that neither consumers nor business can be expected to provide the spending needed to lead us out of recession, it is up to government to provide a stimulus. Given the fact that interest rates are near zero (0.005% yield on 3 mo. Treasuries last week) we are in conditions somewhat reminiscent of 1932 - only government spending is left as a potential tool to stop the downward spiral. A stimulus package should be large (resulting in a fiscal deficit on the order of 10% of GDP) since there is ample scope for monetary policy to slow things down if need be, and we don't want to have to try again after another too-small attempt to stimulate the economy. It should be targeted at areas where the money will be spent quickly (extending unemployment, aid to state governments, immediately implementable infrastructure projects, etc.) since there is a high probability that taxpayers will simply save tax cuts and businesses will not borrow even if credit markets loosen up since demand is falling.

The success of any stimulus hinges on how fast it can be done and if it is large enough - President elect Obama is likely to have at least something of a honeymoon period to get things through Congress and the accuracy of this forecast depends on the rapid passage and subsequent success of his proposed package.

The best that can be expected in 2009 is no growth at all. Far more likely is a decline of 1-2% in GDP, with even worse performance if there are additional negative shocks or if the stimulus package is delayed or too small to be effective. For those wanting to get really depressed, a worst-case scenario would have foreigners and domestic investors resisting additional federal debt, pushing up interest rates and thereby squashing any potential positive effect of a stimulus. However, given that even a large stimulus would leave the debt/GDP ratio well below historical peaks this probably won't happen, particularly given the appetite for Treasuries evinced by nearly everyone in the current crisis atmosphere.

Given the growth projection above, the current 6.7% unemployment will easily reach 8% next year with 9 or even 10% not out of the question depending how good or bad the growth performance is. Inflation is not something we need to worry about. Deflation is even a possibility though not likely given a large stimulus package. The stock market is anyone's guess - stocks tend to recover sooner than the real economy but the only prediction I will make is that there will be very high volatility in the year to come as investors struggle to figure out which way the economy is heading.

The value of the dollar has strengthened in the past few months as investors worldwide have flocked to US Treasuries but it is hard to see it strengthening much more than the current mid 1.20's against the euro. The huge flood of US paper hitting the markets will tend to weaken the dollar over the next year but the fact that interest rates can only go higher in the future will limit downward movements to some extent.

An outline of this year's talk can be found here. The accompanying powerpoint presentation can be found here.

Predictions for 2008

Last year's prediction that we would see the peak of the business cycle in 2007 seem to have been borne out as well as the prediction that the bursting of the housing market bubble would figure prominently in the turnaround. Predictions of further dollar weakness were also borne out with a steep drop vis a vis the euro and some evidence of foreign central bank reluctance to continue buying dollar assets at previous rates.

Accordingly, 2008 is forecast to be a recessionary year for the economy with growth in the area of 1-2% and possibly lower if the credit market crisis can't be contained. This is a real possibility with housing prices already down 7% from their peaks and foreclosures at record rates. The housing market will only come back into balance when house prices fall enough and/or inflation rises enough to restore normal ratios between house prices, rents and incomes. This is unlikely to occur within the next year.

Inflation is likely to be on the high side next year, probably around 5% as oil price increases and dollar depreciation continue to work their way through the economy. Opposing forces are also at work since a severe slowdown would dampen price increases to some extent. Where the dollar goes from here is hard to say - While the long run equilibrium for the dollar is pretty clearly closer to 130 than 1.50 to the euro it has yet to fall substantially vis a vis some other currencies, notably China and Japan.

The Fed will have a balancing act over the next year as credit market mayhem will make them want to lower rates while inflation and dollar weakness will work the other way. However, the Fed will always put domestic considerations before international ones and system stability issues before anything.

Congress can be counted on to do pretty much nothing at all in an election year. There is some possiblity that the Alternative Minimum Tax could be "fixed" but even that isn't a certainty. So, look for paralysis in Washington until a year from now.

An outline of the talk can be found here and a powerpoint presentation with the graphs used to illustrate it can be found here.

Predictions for 2007

From the vantage point of early December 2006 it looks like we are now past the peak of the business cycle that began some five years ago. The Fed campaign of tightening is probably at an end (market expectations are for a rate decrease in March) and while the Democratic takeover of Congress has improved the long run fiscal outlook (those recent tax cuts will likely be allowed to expire by 2010 rather than being made permanent as the President wants) the near term outlook is still for huge deficits.

The housing market was the engine of the expansion over the past few years and the end of the housing boom is what is causing the turnaround in the overall business cycle. Various pieces of evidence point to a peak in housing earlier in 2006 and we are now left to hope that the air goes out of the bubble slowly rather than all at once. Either way, with house price appreciation slowing (or even going negative) and household debt service ratios at record highs there is little scope for consumer spending to prolong the economic expansion.

The European area is continuing to undergo a tightening cycle in monetary policy so there is little help to be expected from that direction while the Chinese economy continues to grow at very high rates. This can't continue forever but there is no particular reason to name a date when it will end. The big danger is that the Chinese central bank will decide to stop buying US government debt which would cause a drop in the value of the dollar. With dollar holdings already in the vicinity of $650-700 billion they could decide to expand in other directions. This would be significant for the US economy, providing additional downward pressure on the already weak US Dollar (now at 1.33 to the Euro) and upward pressure on interest rates.

Predictions for the coming year are: GDP growth around 2% (lower if there is a major political or economic shock) inflation continuing around 3% and interest rates likely to come down (at least at the short end) gradually through the year.

An outline of the talk can be found here and a powerpoint presentation with the graphs used to illustrate it can be found here.

Predictions for 2006

The outlook for 2006 is one of considerable risk depending on several factors affecting the economy. As the Fed continues its campaign of tightening the possibility of a yield curve inversion is very real and could signal the beginning of a slowdown or recession. While Congress cannot be expected to control spending in an election year, more tax cuts are less likely than previously so that our continued descent into ever increasing indebtedness is likely to continue. The question remains as to how big an appetite the foreigners have for our paper - If they decide to stop buying it as readily as they have so far it could mean sharply higher interest rates and a deeper slowdown than we could otherwise see.

Oil prices are another major unknown. They remain much higher than in recent years though they have retreated from spikes in the Fall. Nevertheless, higher oil prices will tend to put the brakes on the economy and consumer sentiment as will higher interest rates.

Political weakness has meant the end of the Social Security proposal of last year (something we should all be thankful for) as well as the tax reform plan. Indeed, even political strength would have been unlikely to make that pig fly since politicians who want to be reelected don't vote to abolish the home mortgage interest deduction.

All things considered, the outlook for next year is 3% growth (higher at the beginning of the year and lower later) and continued moderate inflation barring another major oil price increase. Interest rates are likely to continue higher at the short end, while longer rates will likely respond to a combination of factors including the level of economic activity and the willingness of foreigners to keep funding our deficits.

An outline of this talk can be found here and powerpoint presentation here.

Predictions for 2005

The outlook for 2005 is one of continued unspectacular growth with a significant downside danger stemming from unchecked fiscal and current account deficits. While I called for 3% growth over the coming year, I remain very worried that an exchange crisis could provoke interest rate spikes which would in turn cause a major correction in capital markets and a sharp retrenchment for debt-exposed consumers. It would also result in a much slower growth of the economy overall. Therefore, we should all hope for the alternative scenario of a gradual dollar depreciation and a renewed commitment to fiscal discipline in Washington.

Unfortunately, the White House has espoused policies seemingly designed to exacerbate this problem, including but not limited to: making the previous tax cuts permanent, Alternative Minimum Tax relief, using borrowing to fund the $2 trillion financing gap caused by the Social Security privatization proposal. These, together with conservative estimates of discretionary spending growth yield federal deficit projections that grow continuously as far as the eye can see. As long as this continues the chance of an unpleasant correction (a "hard landing") will grow.

Barring major exchange rate changes, there is little pressure on inflation given still low levels of capacity utilization and a still soft labor market. Interest rates are headed back up though they are still at historically low levels. Again barring exchange rate problems, look for increases on the order of 2-3% over the next year.

Notes from my December 7 talk can be found here. A powerpoint presentation containing graphs and charts for my talk can be found here.

September 2004 Midyear Update

Below are last December's predictions. In September of 2004 they don't look bad - the growth prediction of 4% is perhaps a little high but not seriously off base. As predicted, inflation has not come back, while interest rates are indeed slowly on the rise again. The dollar has not fallen, and has remained in a trading range pretty much where it was last December. The stock market hasn't gone up or down much from where it was.

I am now predicting that growth will continue but at a rather plodding pace of 3% or perhaps even a little less next year. Inflation won't spike unless there is a serious depreciation of the currency and/or oil prices spike substantially. This is because there remains lots of slack in both labor and capacity utilization. The biggest threats are an oil price rise from unforeseen events; a serious consumer retrenchment if spending reacts negatively to interest rate increases in the face of massive debt increases over the past three to four years; a dollar depreciation if foreigners get tired of buying all of our paper.

These predictions were made in a speech in Orlando Florida on Sept. 20, 2004.

Predictions for 2004

Once a year in December I make a public statement of my best guess for the coming year at Cornell's annual Outlook Conference. In December 2002 my talk predicted continued low growth (on the order of 1-2%) with various factors which could influence outcomes as we go along. As things turned out, I was too low in my prediction due to the far larger stimulus than I expected, the continuation of interest rate cuts, and the willingness of consumers to continue piling on debt at an unabated pace.

In December 2003 my talk predicted better growth prospects for the coming year (around 4%), based on the apparent turnaround in the third quarter of 2003, the apparent willingness of the Federal government to run even larger fiscal deficits in the coming year ($375 billion in 2003 and forecast for $500+ in 2004), and the lack of any pressure to raise interest rates in the near term. Most traditional indicators of the business cycle point to an improvement in conditions in the near term.

However, there are reasons to be cautious as to the pace of the recovery. Among the things to watch out for:

- Though unemployment seems to have turned the corner we still have yet to see a convincing turnaround in actual hours worked, which is what puts money in peoples' pockets

- Consumers will have to get the money from somewhere if the recovery is to continue and consumer debt is at record levels. If/when interest rates start up again, there could be a problem

- If foreigners panic and stop wanting to fund our excesses at the rate of $2 billion/day and rising, there could be a dollar panic and higher interest rates, which would dampen our party

In spite of these potential problems, the federal government's completely irresponsible attitude toward long term debt is unlikely to provoke short term problems (barring a foreign creditor panic). Rather, the massive stimulus is likely to win out at the cost of a very unpleasant hangover down the road when we try to retrench. And it will be more unpleasant the longer we put off dealing with it.

Link to Powerpoint Presentation of February 28, 2009

Link to Outline of December 2008 Speech on the Outlook for the Economy

Link to December 2007 Speech on the Outlook for the Economy

Link to Outline of December 2006 Speech on Outlook for the Economy

Link to My December 2005 Speech on the Outlook for the Economy

Link to Outline of My December 2004 Speech on the Outlook for the Economy

Link to Outline of My September 2004 Speech on the Outlook for the Economy