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Friday May 19, 2006 - 19:21:11 GMT
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Forex: Broken Economy Forecast Right At Least Once A Business Cycle

Broken Economy Forecast Right At Least Once A Business Cycle

The US economy may be coming a broken clock...right at least once in the business cycle. The Fed should not let itself get distracted with myopic bond and equity markets in a tizzy over core inflation gains when he much greater danger lies a little further out on the horizon...keeping the US economic on track for a soft landing.

A negative wealth effect could be the wave that flips US Expansion, just like in that awful movie remake of a really awful movie...with all due respect to Shelley Winters. Housing is not just at risk of suffering a correction in prices that transmit to household spending but the stock market is also turning over and most indices are now down for the year. The debt laden household can ill afford a double whammy from lower real estate prices and fall stock prices. The overshooting risk that Yellen has most vocalized and was repeated by Hoenig today is real and involves looking beyond the latest lagging indicator. It also demand a little perspective, something that is in short supply after near 20 years of being led from one data point to the next by the greatest fine tuning Fed Chairman ever - Sir Alan Greenspan. Even Lacker has his Greenspan goggles on.

But there is more than just a negative wealth effect. We are in the midst of an oil is a shock even if it takes time to feed through and even if it is not as significant on relative basis to the 70's quacks like a shock, it walks like a shock... That said I would put it above the Persian Gulf War shock of the early 1990's, by a long shot, and that shock led to a recession that saw Bush41 lose a second term election to Clinton42. Moreover what oil shock has not been followed by a recession?

What are the counter arguments to the US recession forecast which I would put it at by year-end to early 2007? Global economic activity has not been this healthy since the late 90's. The US labor market is buoyant. Business investment is strong. And corporate profits are solid.

The Bernanke belief is that the good side to the economy will cushion the bad side and make for a soft landing. Bernanke is also an expert on how US monetary policy over did it in ever prior oil shock and playing a large role in generating the recession. The mistake was what the bond market nervous Nellies want the Fed to do...panic over core inflation where the main driver in the last two months has been apparel and rent. Last I checked apparel prices are not a market with particularly strong margins outside of luxury goods. And rent? I just rented my NYC apartment after listing it for one week and the second day after the broker had the keys to the second couple who saw it. The agent said the rental market is on fire as buyers are putting off purchases sensing a pull back in home prices behind the growing body of evidence of a slowdown in the housing sector. And the supply of rental units fell sharply in the housing boom as units were rapidly converted from rental to owner. If anything higher interest rates will only drive up rent.

Moreover, throw in the demographic shift. The baby boomers are downsizing for retirement and super sizing benefits (entitlements)...even those with plans to keep working in some capacity have loads of saving to do in the next decade to maintain any semblance of current consumption patterns, especially if home prices fell and stayed down...downsizing real estate to unlock wealth for retirement.

What I think is important is for market participants to not get sucked into the myopic world of data point to data point (like core March and April CPI where rents and apparel drove the move up, not pass through from energy nor from wage or demand pressures) and realize that the medium-term risks of recession are more fundamentally threatening than the near-term risks of rising core inflation. I am not suggesting the Fed will ignore inflation. Indeed it may do what I thought it would not (until recent data), raise rates in June. But beyond June there might be one more rate increase in this cycle. Bernanke and the Fed are not embarking on a new phase of tightenings to take policy from neutral to restrictive.

Indeed my bet is the Fed will be easing by year-end. Near-term, the risk is the Fed responds, like Lacker and many market pros, to the inflation data and hikes in June, flattening the curve. But longer-term the curve faces structural steepening. The willingness of foreign investors to fund the US deficits is in decline. Currency risk, a US slowdown and massive debt burden demands higher rates of return for additional foreign investment in US assets, even at a reduced rate.

I think Bernanke has some explaining to do next Tuesday at the Senate Banking Committee hearing on financial literacy. Instead of telling Congress again why it is important to teach the youth of America the merits of saving, something clearly lost on their parents and grand parents, he should take the opportunity to bring some perspective to the inflation risks of the near-term, lagged effects of monetary policy and the very clear picture of significant headwind for the consumption driven economy in the 2H of 2006. This would not be a hoisting of a white flag of surrender on inflation but would help wean markets off of years of the Greenspan drip-feed. Just then asset bubbles might be harder to come by as risk premia would move toward more historical norms.

David Gilmore


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