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Thursday, July 27, 2006

Roubini: Chance of a Recession Large and Rising

Nouriel Roubini says the chance of a recession is now as high as 50%:

It is hard to predict with certainty whether the U.S. and global economy will suffer of serious stagflation or even a recession (my bearish views are fleshed out in my recent blogs here and here). I have been arguing that those risks are large and rising; and I have recently argued that the probability of a US recession in 2007 is as high as 50%. In brief, the Three Bears of high oil prices, rising inflation leading to higher policy rates, and a slumping housing markets will derail the Goldilocks (of high growth and low inflation) and trigger a sharp U.S. slowdown in 2006, that may turn into a recession in 2007.

One potential barometer of such recession concerns - with all the appropriate caveats - is how many news articles are citing terms such as stagflation, U.S. recession, or recession in general. Here is a brief news-mood summary taken from a brief search on Google News today:

And it is not just obscure publications that are worrying about stagflation and recession. Recent detailed discussions of such risks were recently front page on the WSJ  and on Bloomberg. And the number of private sector folks, experts and academics talking about such risks is rising. The authoritative Mike Mussa, former Chief Economist at the IMF, now puts the odds of a US recession at 25-30% while the Fed's own internal yield curve model now predicts that the probability of a U.S. recession in 2007 is almost 40%. As the proverb says, talk is cheap (if so sweet) but in this case the evidence that many folks and leading media publications are increasingly and systematically talking about recession and stagflation to the tune of  1000s of recent articles and commentaries should be at least a signal, to policy makers and market folks, that these risks may be rising (and the talk is no sweet).

Fed Chairman Bernanke is downplaying the risks of a recessions but many out there are starting to worry about it a lot. The Fed may also want to learn from its previous serious forecasting mistakes. In 2000, it took six months for the U.S. to go from overheating into outright recession: in Q2 of 2000 the economy was growing at an annualized rate of over 5% and it slowed down to close to 0% by Q4 and entered into an outright recession by Q1 of 2001. As late as September 2000, Fed discussions - see their Minutes - were showing the FOMC being mostly clueless about the upcoming recession and still worrying more about the alleged rising inflation (with their view of the balance of risks stressing rising inflation rather than slowing growth). It then took a surprising and lousy Christmas season of sales and a crashing Nasdaq at the beginning of the new year session on January 2nd 2001 to get the Fed into reality check, panic mode and start reducing the Fed Funds rate at an exceptional inter-FOMC meeting point.

And in 2000, the triggers for the recession were surprisingly similar to 2006: then a tech sector investment bust (now a real estate sector bust); then a Fed tightening of 175bps (between June 1999 and June 2000), now a 425bps (soon 450bps) tightening; then a modest oil shock (with oil rising from low teens to high teens in 2000 on the basis of Mid-East tensions and the beginning of the second intifada), now oil rising from $ 20 to 40 to 60 to 75 (and soon enough to 80) on the wave of much more serious Mid-East tensions (Israel conflict with Palestinians and Lebanon, growing security mess in Iraq, rising risks of a confrontation with Iran on the nuclear proliferation issue); then, there were worries - mostly unfounded in reality - on the risks of rising inflation, while now there are much more serious real worries (in spite of Bernanke's latest flip-flop on the issue, to cite Steve Roach today) on a truly rising inflation rate (see also WSJ's Greg Ip on Bernanke keep on saying one thing and doing another for the last few months; so much for Fed transparency and consistency of its communication strategy).

So, why does Bernanke believe that a "U.S. recession is not likely?" Why are things better now than in 2000 when all indicators show similar vulnerabilities but only more severe and scary ones now than in 2000? There are much more severe vulnerabilities now compared to 2000-2001 as today:

  • the U.S. consumer is facing negative savings, rising debt and debt-servicing ratios; is being buffeted by rising rates, rising oil, slumping housing, rising inflation; is experiencing falling real wages and rising inequality thas is slumping aggregate demand. Thus, the US consumer is in much much worse shape than in 2000.
  • When the tech bust led to the  2001 recession, the recession was much more shallow than could have otherwise been as the  U.S. consumer - then strong after a decade of rising real wages and falling income inequality - was very resilient and kept on spending while corporate investment slumped. Thus, the recession was modest and short-lived. This time around the battered U.S. consumer and worker is not resilient at all.
  • Compared to 2000 when the current account deficit was small (and driven by the 1990s investment boom) while fiscal policy was sound (a huge surplus), today the U.S. economy is much weaker with a huge twin fiscal and current account deficit and a structural fiscal deficit.
  • Compared to the post-2001 recession, when the Fed could slash rates from 6.5% all the way down to 1% and Treasury went to a reckless fiscal stimulus (turning a 2.5% of GDP fiscal surplus into a 3.5% deficit), today the levers for policy easing are much more limited. Indeed, given the inflation pressures, the Fed may have to keep on tigthening or at most pause and cannot afford to slash rates. Moreover, the fiscal deficit is such a structural mess that the idea of using fiscal drug stimulus to counter a recession would be outright reckless.

So, today we have much more severe shocks, a more vulnerable economy and much more limited macro policy levers compared to 2000-2001. Thus, the likely coming recession will be much nastier than in 2001. So, Bernanke may want to give some real explanations - not just wishful thoughts - on why he believes things will be fine and the U.S. economy will grow at its potential rate (his own staff is not as optimistic on that predicting growth below potential and falling). So Caveat Emptor...

For more details on my views on the U.S. and global economic growth, inflation, the risks of stagflation and implications for financial markets see my recent blog writings (free for all), audio conference calls, video webcasts and powerpoint presentations (see here and here...).

    Posted by on Thursday, July 27, 2006 at 07:25 AM in Economics, Policy | Permalink  TrackBack (0)  Comments (26)


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