FYI | Oct 31 2006
By Rudi Filapek-Vandyck
Professor of Economics and International Business at the Stern School of Business, New York University ,Nouriel Roubini doesn’t need a dismal US GDP growth figure to conclude that investors are currently walking a dangerous path.
It was only a few months ago that Roubini issued the call the US economy was likely to experience its next recession in early 2007. Right now the view is in sharp contrast with the ruling opinion that all will be just fine and the US economy will land softly throughout 2007.
Roubini, however, has not changed his view.
For more reading visit www.rgemonitor.com
With permission of RGE monitor, we hereby re-publish Roubini’s response to last week’s FOMC statement:
[] The entire industry of “Fed watchers” has been hard at work to interpret the latest FOMC statement where the only difference relative to the previous statement was an additional sentence on growth likely to be moderating ahead. The seeming consensus is that the Fed believes that the victory of a growth soft landing with moderating inflation has been achieved; thus, while a tightening bias is kept as inflation is still above the comfort zone, the Fed is not likely to tighten as the growth slowdown and lower energy prices make a Fed Funds rate of 5.25% just right for the time being. Also, the bond market expectation – stoked by last months Philly Fed report – that the Fed may ease rate as early as January have been – according to Fed watchers and Fed Funds futures – now mostly dashed: the bond market was ahead of the Fed and the expected “soft landing” implies no Fed easing any time soon; if anything the tightening bias keeps the option open that an unexpected rise in core inflation or failure of core to fall in the next few months (together with a growth rebound) may still lead the Fed to tighten some time in 2007, even if the most likely scenario looks like a Fed Funds stop at 5.25% through, at least, the first part of 2007.
Adding my epsilon or delta of interpretation or divination to the meaning of yesterday’s FOMC statement would be useless as there is a whole cottage industry of very good Fed watchers : I would actually call them “Fed-ologists” as they, like the cottage industry of Kremlinologists of the Cold War (who used to try to divine the meaning of the cryptic statements – or even looks and frowns – of Soviet leaders) appear to try to divine the meaning of every word uttered within the FOMC or by Fed governors in their speeches.
So, instead of trying to try to directly challenge the “no-way cuts ahead” message of the FOMC message or divine what Bernanke and his fellow governors really meant, I think it is more productive and value-adding to compare Fed policy and statements in 2006 to those of the Fed in 2000 as they may give a better divination of what may happen ahead. Fed policy and statements in 2000 were amazing as the Fed went from a tightening bias (because of inflation worries) in mid-November to an easing bias (because of faltering growth) in a matter of weeks in late December to an outright cut in the Fed Funds rate two weeks later (at an exceptional inter-FOMC time on January 3rd 2001). So all those Fed watchers who are now cheerfully stating that the Fed will not cut rates in Q1 (or even still believe that the next Fed move will be a hike in early 2007) may find their divinations wrong this time as they were wrong in 2000.
The Fed policy and FOMC statements saga of 2000 is more interesting than trying to interpret the meaning of an extra sentences in yesterday’s FOMC statement.
A little Fed policy history: in 1998 with the Fed Funds rate at 5.50% and an “new economy” speeding at 4% plus growth, the Fed eased the Fed Funds rate by 75bps (with the first cut at an inter-FOMC meeting date) because of the seizure of liquidity in US capital markets following the near collapse of LTCM (that in turn had been triggered in part by the default of Russia in August 1998). That liquidity boost stimulated further the US economy and the bubbly NASDAQ and stock market and, by June 1999, the Fed realized it needed to undo the post-LTCM easing and tighten further as growth was accelerating to 5% and inflation started to rear its ugly head. Thus, between June 1999 and May 2000 the Fed increased the Fed Funds rate by 175bps bringing the level to 6.5%. Note that in Q2 of 2000 the economy was still growing at an annualized rate of 5%; but the bust of the tech bubble – that started in March of 2000 – would lead (together with an oil shock and the Fed tightening) the economy from a 5% growth in Q2 to near zero growth by December and an outright recession that started in Q1 of 2001 that totally surprised the Fed and forced it – in a matter of two months to move from a strong tightening bias to a strong easing bias and then to an inter-FOMC meetings Fed Funds cut just two weeks later.
The story of sudden change in Fed outlook, statements, bias and actual decision in those two months between November 15th 2000 and January 3rd 2001 is more interesting than all the ink spent today trying to divine the next steps of the Fed based on yesterday’s FOMC statements.
So follow me now on this historical detour that has many lessons for today and the recession risks for 2007…
As discussed above by May of 2000 the Fed had tightened by 175pbs and brought the Fed Funds rate to 6.5%. At that time the economy was still growing at 5% rate and the inflation rate was still picking up. Thus, the Fed kept a strong tightening bias but signaling no concern on growth and only concerns on inflation. By June 28th at the next FOMC meeting, there were already signs that the tech stock bust (that started in March) would lead to a slowdown in growth; but the Fed believed in a soft landing and was still more worried about inflation than about growth. Thus, the Fed decided to pause at 6.5% (in the same way in which it decided to pause this year in August at 5.25%) while maintaining a tightening bias. The argument the was that, with the tech bubble pricking, the slowdown of the economy would occur and would slow down inflation; and there was a risk of overkill by tightening more as the Fed hikes in the pipeline (175bps) were still working their effects in the economy (similarities to 2006 are quite amazing).
Note that the Fed in 2000 totally missed the fact that the tech stocks bubble bursting would lead to a sharp contraction of real investment and that this collapse in investment – together with oil now above $30 from low teens earlier and a Fed Funds hiked by 175bps – would spin the economy from 5% growth to a recession in a matter of six months! Then, like now, they worried more about inflation than about growth all the way until November 2000. At the August meeting of the FOMC the Fed make a statement practically identical to that in June that kept the tightening bias:
“The Federal Open Market Committee at its meeting today decided to maintain the existing stance of monetary policy, keeping its target for the federal funds rate at 6-1/2 percent.
Recent data have indicated that the expansion of aggregate demand is moderating toward a pace closer to the rate of growth of the economy’s potential to produce. The data also have indicated that more rapid advances in productivity have been raising that potential growth rate as well as containing costs and holding down underlying price pressures.
Nonetheless, the Committee remains concerned about the risk of a continuing gap between the growth of demand and potential supply at a time when the utilization of the pool of available workers remains at an unusually high level.
Against the background of its long-term goals of price stability and sustainable economic growth and of the information currently available, the Committee believes the risks continue to be weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future.”
Note how the Fed totally underestimated the effects that a quadruple whammy of tech-stocks bust, real tech investment bust, rising oil and rising Fed Funds in the pipeline would do to the economy. In late August they were still worried more about inflation than about growth.
By the next FOMC meeting on October 3rd, the wording of the statement was slightly different but the message identical to that of June and August: soft landing for growth; upside risks on inflation and therefore a strong tightening bias:
“The Federal Open Market Committee at its meeting today decided to maintain the existing stance of monetary policy, keeping its target for the federal funds rate at 6-1/2 percent.
Recent data have indicated that the expansion of aggregate demand has moderated to a pace closer to the enhanced rate of growth of the economy’s potential to produce. The more rapid advances in productivity also continue to help contain costs and hold down underlying price pressures.
However, the utilization of the pool of available workers remains at an unusually high level. Moreover, the increase in energy prices, though having limited effect on core measures of prices to date, poses a risk of raising inflation expectations. The subdued behavior of those expectations so far has contributed importantly to maintaining an environment conducive to maximum sustainable growth.
Against the background of its long-term goals of price stability and sustainable economic growth and of the information currently available, the Committee believes the risks continue to be weighted mainly toward conditions that may generate heightened inflation pressures in the future.”
Even by November 15th 2000, at the following meeting of the FOMC, Greenspan and his fellow governors were still clueless about how the quadruple whammy of shocks were fast pushing the economy into a recession. They were still worrying about inflation risk and still deluding themselves that growth would slow down but achieve a soft landing. Thus, even as late as November 15th 2000 they kept the same tightening bias that they had had throughout 2000 and after the May pause; almost nothing had changed in their blinded eyes since June (apart of a mention of growth now expected to be below potential for a time) in spite of plenty of signs of a sharp slowdown of the economy and a free fall since the spring of the NASDAQ, S&P and other stock indexes:
“The Federal Open Market Committee at its meeting today decided to maintain the existing stance of monetary policy, keeping its target for the federal funds rate at 6-1/2 percent.
The utilization of the pool of available workers remains at an unusually high level, and the increase in energy prices, though having limited effect on core measures of prices to date, still harbors the possibility of raising inflation expectations. The Committee, accordingly, continues to see a risk of heightened inflation pressures. However, softening in business and household demand and tightening conditions in financial markets over recent months suggest that the economy could expand for a time at a pace below the productivity-enhanced rate of growth of its potential to produce.
Nonetheless, to date the easing of demand pressures has not been sufficient to warrant a change in the Committee’s judgment that against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks continue to be weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future.”
Then, suddenly the disaster came with the force of an unexpected tsunami: unexpected only in the eyes of the Fed that – for six months – had totally underestimated the effects that the tech-stocks bust, the real tech investment free fall, rising oil prices and Fed Funds hikes in the pipeline would do to the economy. By late November and early December it was clear that the real investment was sharply falling and that the retail sales in the Christmas season would be lousy. The economy was sharply slowing down by November and clearly contracting by early December. Given the onslaught of bad macro news it was impossible – even for the Fed – to avoid seeing the sharp slowdown in the economy. Thus, in a major flip-flop in the six weeks between November 15th and December 19th, the Fed moved from a strong tightening bias to a strong easing bias; as the December 19th FOMC statement was now realizing the economy was entering in a sharp slowdown even if the Fed did not explicitly express concerns about the outright recession that was by then already underway:
“The Federal Open Market Committee at its meeting today decided to maintain the existing stance of monetary policy, keeping its target for the federal funds rate at 6-1/2 percent.
The drag on demand and profits from rising energy costs, as well as eroding consumer confidence, reports of substantial shortfalls in sales and earnings, and stress in some segments of the financial markets suggest that economic growth may be slowing further.[bold added.] While some inflation risks persist, they are diminished by the more moderate pace of economic activity and by the absence of any indication that longer-term inflation expectations have increased. The Committee will continue to monitor closely the evolving economic situation.
Against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the Committee consequently believes that the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future. .[bold added]”
Then, in a matter of two weeks, the Fed moved from its easing bias to an outright cut in the Fed Funds rates on January 3rd 2001 in an exceptional decision in between FOMC meetings. What triggered this sudden decision? Right after Christmas, the actual holiday season sales figures came out and they were even worse than the bad figures that most had expected before the holidays. Then, on January 2nd 2001 the NASDAQ market opened during its first trading session of 2001 and it fell 7%. At that point the Fed went into panic mode and the “Greenspan put” was exercised: on January 3rd the Fed cut the Fed funds rate by 50bps in a surprise in-between FOMC meeting move and signaled a further easing bias:
“The Federal Open Market Committee decided today to lower its target for the federal funds rate by 50 basis points to 6 percent.
In a related action, the Board of Governors approved a 25-basis-point decrease in the discount rate to 5-3/4 percent, the level requested by seven Reserve Banks. The Board also indicated that it stands ready to approve a further reduction of 25 basis points in the discount rate to 5-1/2 percent on the requests of Federal Reserve Banks.
These actions were taken in light of further weakening of sales and production, and in the context of lower consumer confidence, tight conditions in some segments of financial markets, and high energy prices sapping household and business purchasing power. Moreover, inflation pressures remain contained. Nonetheless, to date there is little evidence to suggest that longer-term advances in technology and associated gains in productivity are abating.
The Committee continues to believe that, against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future.[bolds added]”
The rest of the story is known. The Fed cut the Fed Funds from 6% to 5.5% at its January 30-31st meeting and then again down to 5% at its March 20th meeting. Even that was not enough to prevent the sharp recession that hitting the economy and the Fed panicked again in April and decided to cut the Fed Funds rate to 4.5% again in between FOMC meetings on April 18th. By December the Fed Funds rate was down to 1.75%! It is interesting to notice that, during that period where the economy was entering a recession almost all of professional macro forecasters were still deluding themselves that a recession in 2001 would not occur. In March of 2001 95% of all economic forecasters predicted no recession that year; too bad that the economy had already entered into a severe recession by that March data. The wishful hope of forecasters and markets was that the “Fed easing would rescue the economy” and that the economy would experience a “second half rebound”. Indeed, as in typical suckers’ rally mode, the S&P index rallied a whopping 18% in April and May 2001 hoping that the Fed easing would prevent a recession. It was only in June 2001 when even more severe signs of a recession clearly emerged that the stock market started to rapidly tank and entered into a free fall. So, such stock markets suckers’ rallies are very common at the outset of recessions. The reality is that stock markets are at times wrong: sometimes they predict recessions that do not occur but, at times like in 2001, they fail to predict recessions that are already ongoing. Thus, you can expect the current suckers rally to continue until, by late 2006, it is clear that a recession is coming and that a Fed ease in 2007 is not going to rescue the economy.
What are thus the lessons for 2006 from this 2000-2001 experience? Several ones.
- The Fed totally missed the sharp slowdown in the economy and, even when it noticed it too late, it expected a soft landing of the economy rather than the recession that started by the end of 2000. Today, the Fed and the markets and the forecasters are again expecting a soft landing while the economy has already slowed down from 5.6% in Q1 to 2.6% in Q2 to even lower in Q3 (the first estimate of Q3 growth is out tomorrow Friday 10/27; my own forecast – since July – has been 1.5% or even lower and as low as 1%).
- The Fed kept a tightening bias – as it was worried about inflation and missed the growth slowdown – all the way until late mid November; and then it flip flopped in December with an easing bias; and then it went into a panic mode two weeks later and cut rates on January 3rd in between FOMC meetings. Could it happen again in early 2007? Of course if the sharp 2006 Q3 growth slowdown gets worse – as I expect – in Q4.
- 95% of macro forecasters were also clueless as late as March 2001 when the recession had already started and they were still expecting a soft landing and no recession in 2001. They all hoped about a rebound of the economy in the second half of 2001; now, given that they totally missed the slowdown in Q2 and they even missed in a bigger way the slowdown in Q3, they are all talking about the Q4 rebound at a time when the first leading indicators for October are signaling more weakness in Q4 than in Q3. The same is happening today: Fed, almost all of the forecasters and the stock markets are hoping for a soft landing that may not occur. Policymakers, forecasters – and sometimes even markets – systematically fail to predict recessions, as a large academic literature has widely shown.
- The stock market was also clueless about the recession and had a suckers’ rally of 18% in April and May 2001. Today, you have the same suckers’ rally and expect this equities suckers’ rally to continue even after the Fed signals a coming easing when recession signals become even stronger than today.
- The slashing of the Fed Funds rate in 2001 from 6.5% to 1.75% did not prevent the recession as the glut of capital goods made investment insensitive to interest rate cuts (even long rates fell sharply in 2001 with no effect on the economy). Today, even a sharp Fed Funds cut in 2007 will not prevent the likely 2007 recession as we have a glut of housing, a glut of autos and a glut of consumer durables related and unrelated to housing (home appliances, furniture, etc.).
Could I be wrong in my 2007 hard landing and recession call? Could the economy have a soft landing like it did in 1994-1995 rather than the hard landing of 2000-2001? Of course that is possible: we may still get a soft landing; but my reading of the data, so far, is that 2006 looks more like 2000 than 1994. In a separate paper/blog I will compare current conditions to those in 1994-1995 and those in 2000-2001 to show that a 2007 hard landing is much more likely than a soft landing. But the Fed saga of 2000-2001 is a good cautionary tale of how the Fed, the macro forecasters, the financial markets and the stock markets may, at times, totally miss coming recessions. I am thus wary of how policymakers, forecasters and markets are now again glibly discounting the risks of a hard landing and deluding themselves that only a soft landing is possible. They were wrong in 2000-2001 and they may be proven wrong again in 2007.