A Window of Opportunity
The U.S. economy is now in a clear window of vulnerability, given the plunge in ECRI’s Weekly Leading Index (WLI) since last spring. Yet there is a brief window of opportunity within that window of vulnerability to avert a recession. That is why ECRI has not yet forecast a recession.
WLI growth accelerated to a three-year high last June, anticipating the quickening in GDP growth to a four-year high in the third quarter of 2007. The economy’s resilience surprised most economists, given the earlier Fed rate hikes and oil price spikes – a combination that had helped trigger earlier recessions. But the strength in the WLI underscored the economy’s buoyancy, correctly ruling out a recession.
WLI growth then turned down sharply, and, by year-end, had plunged to its worst reading since the 2001 recession. This indicated an economy seriously vulnerable to recessionary shocks.
As a result, a self-reinforcing downturn has already begun. If allowed to continue, it will amount to the vicious cycle known as a business cycle recession. During such vicious cycles, pullbacks in spending lead to production cutbacks, which lead to employee layoffs and declines in income, which in turn feed back to lower spending and production and so on. Still, this does not mean a recession is already baked in the cake.
Imagine a large Roman column that has just started to topple. At that moment, a modest push back near the top would be enough to right it again. But if its fall gains momentum, it would be virtually impossible to stop it from crashing down. Today, the column that is the expansion has just begun to tip.
At this juncture, prompt stimulus to boost consumer spending can avert a recession. But time is truly of the essence – the stimulus is needed in a matter of weeks, not months.
In averting recessions, the timing of policy is often the key. In September 2000, for example, we warned: “Never in this expansion have the leading indicators been so close to forecasting a recession. Luckily, underlying inflationary pressures have already turned down.”
But it was not until three months later that the Federal Reserve shifted from a tightening bias directly to an easing bias before beginning an aggressive rate cut cycle a few weeks later, in early January 2001. It was
not enough to avoid a recession.
In the lead up to the 2001 recession, misplaced inflation concerns inhibited Fed rate cuts for much too long. In the current cycle, once again, inflation concerns held the Fed back from large rate cuts until recently. Yet in both cases, ECRI’s Future Inflation Gauge, a forward-looking measure of underlying inflation pressures, has been in an unambiguous cyclical downswing, giving the green light to rate cuts months before they
Yet all is not lost. How can that be, given the weakness of the WLI?
Self-Fulfilling or Self-Negating?
If we have a recession this year, it will be the best advertised in history. Recently, several Wall Street houses joined the 70% of Americans who have been expecting a recession for the last few months. A number of other prominent economists boosted their estimates of the probability of a recession above 50%.
Yet such probability estimates imply that a recession is a matter of chance, whereas it is still a matter of choice. This is why, having correctly predicted the last two recessions in real time without crying wolf in between, we are not forecasting one yet.
If we have a recession this year, it would turn out to be the most widely anticipated recession in history. Clearly, the pessimism of consumers and business managers could cause them to cut spending, creating a selffulfilling recession prophecy. But there is another side to the story.
The biggest negative impetus in any recession comes from the manufacturing sector, driven mostly by the inventory cycle. Unaware of an approaching recession, businesses typically produce goods in anticipation of rising demand. When, to their surprise, demand for their products starts falling, inventories mount rapidly, forcing sharp production and job cutbacks, thus reducing income and spending power. The spending cuts force further production cutbacks to work off the excess inventory.
This time, prolonged pessimism about the economy, along with a surprise acceleration in growth through last summer, has resulted in a sharp drop in business inventories, taking the inventory/sales ratio to a record low. Thus, there is very little inventory left to whittle down in response to slackening demand.
Therefore, the inventory cycle downturn responsible for most of the downward impetus in a recession is likely to be less powerful this time. Also, if timely stimulus results in a quick burst of consumer spending, it will force manufacturers to boost production instead of reducing inventories. That is why prompt stimulus could be unusually potent in this cycle.
Global pessimism about the U.S. economy has resulted in a major decline in the dollar, making U.S. exports much more competitive. Therefore, U.S. export growth will strengthen further, boosting production. In fact, the latest industrial production data overshot consensus expectations because of the strength of exports.
The unusual decline in inventories and the boost to exports in this cycle have been the paradoxical results of widespread pessimism. Especially if stimulus is prompt enough, this may result in a self-negating prophecy of a recession.
The Need for Speed
At ECRI, we do not take positions on the content of policy. What we are emphatically pointing out today is the extreme importance of the timing of stimulus.
At turning points, a few months’ lag in policy action can be immensely costly. If it spells the difference between a recession and a soft landing, a couple of months’ delay can end up costing a couple of million jobs and couple of hundred extra basis points in rate cuts – and still not have the same effect. What a stitch in time can accomplish early in a down cycle cannot be achieved, even with far more aggressive action, a few months down the road. At best, forceful but delayed action can mitigate the severity of a recession.
The danger is that fiscal policy makers, who can still shore up the “stone column” of the economy that has begun to tip, may waste time designing a safety net to catch the falling column, instead of trying to stabilize it quickly in order to avert a recession. But the outcome is not pre-ordained, and the WLI will promptly let us know whether policy action, in conjunction with the forces pushing toward a self-negating recession, can successfully abort the self-reinforcing downturn.