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Rose Colored Glasses Cloud 'Soft Patch'


When production, employment, sales and income data started coming in much weaker than expected this summer, there was a lot of talk about how the U.S. economy hit a soft-patch.

The consensus among market experts continues to hold that it will soon reaccelerate to a robust pace of growth. A good part of the reasoning for that view is that the slippage in growth was caused by higher oil prices, and that this is a transitory problem.

In fact, the reality is different. The Economic Cycle Research Institute's leading indicators of the economic cycle, which have been declining since the spring of 2004 correctly anticipating the "soft-patch," have yet to turn up. Until they do, it's a good bet that economic growth will not snap back to the pace seen early in the year.

At the risk of scrambling metaphors, experts seem to have moved the goal posts in terms of growth expectations and then stuck their heads in the sand. Now they're missing the forest for the trees.

To view oil prices as the only culprit responsible for the weakness of the economy is to obsess over the obvious problem while missing the broad cyclical downswing in economic growth that's the root of the issue. The fact is that the U.S. economy is in a growth rate downturn that's likely to persist through year-end, if not longer.

In the early summer when the soft-patch thesis was first rolled out, analysts were trying to explain weakness in the economic data that had taken the markets by surprise.

According to the prevalent story at the time, rising energy costs had robbed the economy of its strength (even though the same analysts had also argued that the economy was less vulnerable to rising energy costs because of increased efficiency). Still, the message was clear. As soon as oil prices receded, strong economic growth would be back on track.

Then the data kept coming in weaker than expected. No problem, the soft-patch thesis was flexible, and was stretched by economic forecasters to cover the entire summer. The suggestion that when the soft-patch passed we would return to robust growth was conveniently forgotten. Most observers cheered when Fed Chairman Alan Greenspan recently noted that the economy "regained some traction."

There is room for interpretation of his words, but one would be hard pressed to equate "some traction" with robust growth.

Blame It On Oil

Using oil prices to explain why forecasts are off seems like a classic example of what psychologists call "attribution bias," the tendency people have to take credit for good outcomes while blaming other people or circumstances for bad outcomes.

But when that mantra needed a break, one could simply find other ways to ignore the numbers that didn't agree with the soft-patch view. Take a look at the next weaker than expected economic report and you'll see this process in action.

Sure, hurricanes hurt sales (but they probably help sell plywood as people board up their homes) and they were duly held responsible for disappointing retail sales figures. But this overlooks the Fed's assessment, shared via the Beige Book, that noted "lackluster retail sales" around the country - including areas unaffected by stormy weather.

The optimists, who constitute the majority of analysts today, would prefer to believe the main thing troubling the economy is high oil prices. Thus, the inevitable retreat in those prices should lead to a restoration of the nirvana of strong growth and low inflation.

The reality is that underlying inflation pressures haven't yet turned down decisively, as shown by ECRI's Future Inflation Gauge. It's designed to anticipate cyclical turns in the inflation cycle and remains elevated.

All the major sectors of the economy - manufacturing, services and construction - are being affected by the slowdown, despite continued strength in residential housing.

The deceleration in U.S. growth is part of the larger cyclical slowing in the global industrial sector that also began this summer. Under the circumstances, those who expect robust growth to return in short order are likely to once again be blindsided by a cyclical shift in the underlying trend - in this case toward an easing in U.S. economic growth.

A Choice Of Head Fakes

Of course, oil price increases act like a tax on the consumer, and tend to dampen economic activity. It was entirely plausible that the drop in June industrial production and the weakness in the June and July payroll jobs reports may have exaggerated the softness in the economy. Accordingly, some improvement in subsequent months' readings would be quite reasonable.

A good example is the rise in industrial production in July and August after the drop in June. This has been widely heralded as a harbinger of a return to robust growth, even though the numbers have been below the consensus forecast. In effect, the unsurprising rebound in the numbers from unusually weak readings is the real head fake obscuring the underlying downturn in economic growth.

Essentially there is a choice of head fakes. Either the last few months' weakness is an anomaly temporarily masking the strength in the economy, or the modest but predictable rebound in the numbers is misleading those who are still reluctant to concede the reality of the slowdown.

There is no ambiguity about the interpretation according to ECRI's indexes. From the cyclical vantage point, growth will remain lackluster through the end of the year, making a quick return to robust activity highly unlikely.

Despite the downturn in the growth rate of the economy, there's no indication from ECRI's leading indexes that a new recession is on the horizon. As long as that is the case, it is improbable that any shock, including an oil shock, will be able to trigger a new contraction.

In fact, the likelihood of an imminent recession triggered by high oil prices remains remote, even if the Fed continues to raise interest rates.

Lakshman Achuthan is the managing director of the Economic Cycle Research Institute, (ECRI), an independent organization focused on business cycle research and forecasting in the tradition established by Geoffrey H. Moore. Lakshman is the managing editor of ECRI's publications, a member of Time magazine's board of economists, the Levy Institute's Board of Governors and the New York City Economic Advisory Panel. He is co-author of "Beating the Business Cycle: How to Predict and Profit from Turning Points in the Economy" published by Doubleday (2004). Opinions expressed are those of the author not of Dow Jones Newswires.