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No double-dip recession

The good news is that the much-feared double-dip recession is not going to happen.

That is the message from leading business cycle indicators, which are unmistakably veering away from the recession track, following the patterns seen in post-World War II slowdowns that didn’t lead to recession.

For 25 years, we’ve personally spent every working day studying recessions and recoveries. Based on our work and that of our colleagues at ECRI, we’ve called the last three recessions and recoveries without any false alarms, including an accurate forecast of the end of the most recent recession in the summer of 2009.

After completing an exhaustive review of key drivers of the business cycle, ranging from credit to inventories and measures of labor market conditions, we can forecast with confidence that the economy will avoid a double dip.

But the bad news is that a revival in economic growth is not yet in sight. The slowing of economic growth that began in mid-2010 will continue through early 2011. Thus, private sector job growth, which is already easing, will slow further, keeping the double-dip debate alive.

Of course, it is the renewed job market weakness, combined with deflation fears, that is behind the Fed’s promise to implement a second round of quantitative easing, or QE2.

The QE2’s Problem: Turning Radius
The worse news is that, even without the nightmare of a new recession, an uglier scenario may still lie ahead in the form of unintended consequences of such Fed stimulus.

Fed policy shifts have been chronically late, resulting in the need for increasingly heroic measures to right the economy.

Because monetary policy acts with "long and variable lags," the Fed should, in principle, rely on forward-looking measures to time its actions. Yet, in practice, it does pretty much the opposite, relying on backward-looking statistics like core inflation and hard-to-assess measures of the so-called output gap, including estimates of "full employment."

In early 2010, when we warned publicly of an approaching slowdown, a sanguine Fed was plainly focused on its "exit strategy" to remove the trillions of dollars of cash it had injected into the economy after cutting short-term interest rates to near zero -- only to belatedly reverse its stance some weeks ago.

This is hardly the first time the Fed has been spectacularly behind the curve in detecting a turn in the business cycle.
In mid-2003, the last time “core” inflation was this low, the Fed cut rates to just 1% and kept it there for a year, contributing in no small measure to the inflation of the housing bubble that ended so disastrously.

In mid-2008, oblivious to the recession that had begun six months earlier, they telegraphed to the markets a 50% increase in rates by year-end, from 2% to 3%, in order to fight inflation.

The consequences of these mistakes played out in the subsequent quarters and years to the severe detriment of the economy. But today the fallout from such timing errors, which are likely to set off bigger boom-bust cycles with more frequent recessions, could be far greater with the Fed’s balance sheet as gigantic as it is, and poised to expand further.

In fact, the Fed is about to launch QE2 because it believes inflation to be too low, which really means they are willing to go to new extremes to head off the risk of deflation. Yet, over the last two centuries the U.S. economy has seen sustained deflation only when it has mostly been in recession -- a scenario that our analysis rules out for now. While the current expansion is likely to be shorter than anyone is used to, its demise in not imminent.

Today, the car that is the U.S. economy is crawling uphill, slowing as its engine sputters. With politicians fighting about whether to use a screwdriver or a spanner to fix the motor, the Fed is convinced we’ll end up using neither. Determined not to let the car start rolling back disastrously downhill, yet unaware that the road is about to level off, the Fed is strapping an untested rocket onto the car in hopes of blasting it over the top.

The Fed, looking out the rear-view mirror to steer the car, won’t know when we’re approaching a bend in the road, though we’re now high up in the mountains, with a dangerous abyss below.

Lakshman Achuthan and Anirvan Banerji are, respectively, co-founder and chief operations officer and co-founder and chief research officer of ECRI, the Economic Cycle Research Institute.