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A Forecast for a Fork in the Road


NEARLY six years ago, when most forecasters were still whistling past the graveyard, a small outfit in New York known as the Economic Cycle Research Institute said the 1990's boom was over and made a recession call. With factory orders plummeting and goods piling up in company warehouses, the institute said big job cuts were sure to follow.

It was a pretty gutsy move at the time. Alan Greenspan, then the Federal Reserve chairman, and just about every major Wall Street firm were saying in early 2001 that the Fed's aggressive interest rate cuts would lift consumer spending and prevent a recession. In truth, one had already begun.

An economist named Geoffrey H. Moore founded the institute in 1996, at the age of 82, after a long career in academia inventing some of the leading indicators that are still used to forecast the economy's direction. He had been a student of one future Fed chairman -- Arthur Burns, a founder of business-cycle analysis; and a teacher of another -- Mr. Greenspan, who took Dr. Moore's Statistics I class at New York University in 1946. A half-century later, Mr. Greenspan told Congress that he closely followed all of Dr. Moore's work (though perhaps not closely enough).

Dr. Moore wasn't perfect, but he was quite good. His formulas, which bested Wall Street's rose-colored forecasts by relying on historical patterns, predicted the downturns of both the early 1980's and early 1990's and didn't make an incorrect recession call in either decade. After he died in 2000, his former colleagues predicted the 2001 recession using the indicators he'd created.

The economy has now come to one of those turning points that Dr. Moore loved. When this summer began, growth was moving along at such a nice clip that the Fed was trying to slow it down to keep inflation in check. But as Labor Day and the unofficial start of the work year arrive next week, the situation feels very different.

The long-feared housing slump is here. Automobile sales have been falling. Gas still costs more than $2.80 in most of the country. The shopping slowdown that had already hit Wal-Mart has spread to more upscale chains like Starbucks and Whole Foods, as Daniel Gross first pointed out in Slate magazine.

Perhaps most telling, the people at the Economic Cycle Research Institute are getting nervous. “We're not calling for a recession yet," Lakshman Achuthan, the institute's managing director, told me. “But the risks to the economy have materially increased."

ADD his concern to some other indicators starting to flash red, and I think it's reasonable to put something close to 50-50 odds on a recession starting sometime in the next year.

There are two big reasons you aren't hearing this from Wall Street's experts or, for that matter, the Fed's. The first is that they are all in the optimism business. Investment firms sell stocks and make mergers happen, and doing so is a lot harder if they're also telling people that the economy is about to tank.

The Fed, meanwhile, carries enormous prestige, and if its top officials talked about the possibility of a recession, they could spook households and businesses into causing one. Besides, it is part of their job to prevent recessions, so they tend to believe that they are succeeding.

The second main reason has nothing to do with self-interest. Recessions, often defined as two consecutive quarters in which the economic output declines, are simply hard to call. They are a result not just of economic fundamentals like rising inventories but also of psychology. The moment an executive decides that the economy is slowing and opts not to order a new computer server, she makes a downturn more likely. A homeowner who gives in and finally cuts the asking price on his house does the same.

Economists often pick up on these subtle shifts, even if they don't put the pieces together. Every three months, the Philadelphia Fed surveys about 50 economists, mostly from Wall Street, and asks for their forecasts, which are almost always sunny. But, fortunately, the Fed also asks them to put a percentage on the chances that the economy will shrink in each of the next five quarters.

These percentages make up something I named the Anxious Index a few years ago, a term the Fed has since adopted, and the index has been far more prescient than the economists' headline forecasts. Since 1968, when the forecasters have said that there is a 30 percent chance or better that the economy will shrink in the following quarter, it almost always has. (The 1987 stock market crash, which didn't produce a recession, is the one exception.)

In the most recent survey, released Aug. 14, the economists put only a 10 percent chance on a downturn in the fourth quarter of this year. Further out, however, they were less confident. They said there was a 16 percent risk that the economy would shrink two quarters from now. About 40 percent of the time they have gotten this anxious in the past, a recession has started at some point during the following year.

This cycle is probably even harder to predict than most, because of the mix of economic strengths (like the healthy balance sheets of banks and companies) and weaknesses (like the iffy balance sheets of consumers). Not even the job market offers a clear picture, which makes the Fed's job trickier. If you look at highly skilled jobs, be they in engineering or general contracting, the economy seems quite strong, as Ben Bernanke, the Fed chairman, has said. But for workers without college degrees or specific training, this looks a lot like a slump.

In its annual report on the economic state of the nation, the Census Bureau said yesterday that median household income rose 1.1 percent last year, after adjusting for inflation, but the increase was apparently a result of payments that come from the government and from investments, not from paychecks. The earnings of full-time workers failed to keep up with inflation.

At the Economic Cycle Research Institute, the forecasters have noticed that the last six months bear a striking resemblance to two different kinds of periods: the run-up to a gentle slowdown, like those of the mid-1980's and mid-90's, and the run-up to recession. In both situations, consumer expectations fall while interest rates and inventories rise, which has already begun to happen. But the two paths -- slowdown and recession -- historically diverge sometime after the six-month mark. Starting Friday, with the August employment report, we will begin to get a sense of which road we're going to take.

I hope you enjoyed your summer.
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