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Goldilocks Has Just Left Town

According to a recent poll, 65% of Americans believe the economy will soon be in a recession, if it isn't already in one. That can't be good news for retailers this holiday season.

But last week's GDP report also showed the economy growing at its strongest pace in a year and a half. Inflation was falling to a 44-year low and the employment report showed payroll jobs growing at their strongest pace since last spring. That's a textbook Goldilocks economy.

That's just what the Economic Cycle Research Institute's indicators telegraphed last April, when I discussed ECRI's forecast of a Goldilocks economy, but "a Goldilocks with a couple of blemishes," such as housing. Under the circumstances, I wrote, "U.S. economic growth will firm in the coming months" -- precisely what transpired, contrary to the consensus. As blemishes sometimes are, housing is proving a persistent one.

At the time, Wall Street economists and financial markets were expecting significant economic weakness, and therefore multiple Fed rate cuts, in 2007. But with their rear-view mirrors showing an actual rise in median home prices, they then had a change of heart. So much so that by June 2007, a survey found that by a 3-to-1 ratio, economists thought the worst of the housing bust was behind us.

By early June, with economic growth unexpectedly strong, Liz Rappaport was reporting that "the rate cut calls are dropping like flies in the offices of Wall Street's economists as they have on Treasury bond trading floors and futures trading pits." Completely blindsided by the strength of the economy, they were forced to slash their 2007 rate cut forecasts from a range of 75 to 100 basis points to zero.

Such an overnight about-face is not common among Wall Street economists. For adjustable-rate mortgages due to be reset in the coming months, the likelihood of rates staying high was bad news indeed. The revised expectations reduced their value, especially in the subprime category, which suddenly looked much more vulnerable to rate resets. It was this abrupt invalidation of pessimistic projections that helped precipitate the credit crisis -- in turn damaging the home price outlook.

Still, consider how perverse the economy has been, repeatedly confounding the consensus. After all, the lagged effects of a long series of Fed rate hikes, combined with a major oil shock, has been enough to trigger many a past recession. Add to that a sharp housing downturn, and you can see why most economists thought that a recession was a good bet.

An inverted yield curve, which many consider the best predictor of recessions, only bolstered their confidence. You can see why few shared ECRI's relatively sanguine stance last spring. However, the economy refused to oblige. The credit crisis renewed the chorus of recession calls.

Since then, we've seen a sharp rise in recession probability banter. Yet when someone says they see a 50% chance of recession, aren't they simply saying they're clueless about whether a recession is coming? A coin flip would be about as useful. Saying that the recession probability is between a third and a half is hardly any better. What's a decisionmaker supposed to do with such information?

Think about it. Contrary to all the bearish commentary you may have heard, GDP has grown at a 3.9% annual pace in the last two quarters in the U.S. -- much stronger than in the eurozone or Japan.

Statistics have little power to convince those who refuse to see reality. But it was the strength of the U.S. economy going into the credit crisis that allowed it to plow ahead in the face of the market turmoil and growing worries among Americans. The economy was simply too resilient to buckle under.

But where do we go from here? For the answer, we turn again to ECRI's Weekly Leading Index, which is designed to predict recessions without raising false alarms. As the chart shows, the WLI did drop in August, but has since stabilized. That recent dip is not much bigger than many past downticks that did not lead to recession, and far smaller than the downturns that preceded the 1990-1991 and 2001 recessions.

It's worth remembering that this index helped us predict those recessions in real time, not merely in hindsight. Today, it's certainly pointing to slower growth ahead, but not a recession.

Still, there's some good news. ECRI's Future Inflation Gauge, designed to measure underlying inflation pressures, remains in a clear cyclical downturn. Despite higher prices for food and energy, the falling dollar and the spike in gold prices, inflation pressures are still restrained.

Here's a piece of anecdotal evidence. Three years ago, I suggested keeping track of Chinese food prices because Chinese consumers spend 37% of their budget on food. The price of food has surged in China as pork prices have skyrocketed, due in part to blue ear disease in pigs. Even with the Chinese government releasing some pork from their "piggy bank" -- also known as the strategic pork reserve -- pork prices have taken off, putting upward pressure on labor costs. No wonder the prices of Chinese exports to the U.S. have risen sharply.

But what's been Wal-Mart's (WMT) response? It's actually cut the prices of thousands of items, including Chinese toys, based as usual on what the market will bear. As the FIG objectively indicates, U.S. inflation pressures remain in check despite rate cuts. And that means that the Fed still has room to ease.

Though the WLI doesn't see a recession ahead, economic growth will certainly slow, and monetary policymakers have more room to maneuver than people think. In other words, Goldilocks has left town.

Still, a recession -- involving a plunge from almost 4% to negative GDP growth -- is not likely in the next few months. When the danger actually begins to mount, the WLI is likely to flag it in advance.

Anirvan Banerji is the director of research for the Economic Cycle Research Institute, which was founded by Dr. Geoffrey H. Moore, creator of the original index of leading economic indicators (LEI) for the U.S. Department of Commerce. Banerji is the co-author of Beating the Business Cycle: How to Predict and Profit From Turning Points in the Economy and is the president of the Forecasters Club of New York.