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There is an unusually divergent set of views regarding the economy’s near-term prospects.

• Those who believe that a recession is likely point to the inverted yield curve and a sharply weaker housing market.
• Others believe that growth will remain firm and inflation will accelerate further, forcing even more monetary tightening.

The most likely scenario is that the economy will avoid recession, but growth will remain below the economy’s potential for long enough to alleviate inflation pressures and forestall further Fed tightening.

Debate over the economy’s near-term prospects has become notably divided. There is a small, but vocal and respected, group of economists arguing that the economy will soon devolve into recession. In this view the Federal Reserve will soon be forced to backpedal and sharply lower interest rates. There is an equally vocal and respected group arguing that growth will remain firm and that the principal risk is that underlying inflation, which is already undesirably high, will accelerate further. According to this view the Federal Reserve’s tightening campaign will soon resume.

Our view is that the expansion will remain firmly intact, but that growth will slow sufficiently to lead to moderating inflation. The monetary tightening cycle is over, and while the Federal Reserve may very well ease next year to ensure that growth doesn’t slip too far below the economy’s potential, any rate cutting will be modest.

Recession scenario

Those arguing that recession is imminent point to the inverted yield curve, the sharp decline in housing activity and the negative secondary effects this will have on consumers responding to falling house prices and curtailed mortgage equity withdrawal. The Treasury yield curve has completely inverted, with the 10-year Treasury yield falling well below the 3-month T-bill yield on an equivalent bond basis. For nearly 50 years such an inversion has always preceded a downturn, and there has never been an inversion without a downturn following.

Inverted yield curves have also historically had a direct impact on the economy through the availability and cost of credit. Commercial banks and thrift institutions, who not long ago were the principal sources of corporate and household credit, were less willing to extend loans as their own costs of funds, which are tied to short-term rates, rose above the return on those loans, which are tied more closely to long-term rates. Without credit, businesses and consumers pulled back and recession ensued.

Housing’s sharp slide is adding weight to the recession scenario. Home sales are plunging, unsold inventories of homes are surging, home construction is falling and house prices appear very fragile and set to decline measurably. Those who foresee recession believe that the heretofore housing correction is degenerating into a crash. Sentiment among homebuyers, lenders and regulators, they argue, is shifting from wild optimism to dark pessimism. Mortgage defaults will rise as resetting ARMs bump up against weaker house prices, and lenders taking property in repossession will sell at deep discounts, inducing widespread double-digit house price declines.

Eroding housing wealth will undermine consumer confidence and spending. The ability of lower- and middle-income households to pull cash from their homes through mortgage equity withdrawal (MEW) has supercharged the wealth effect. During the first half of the year, MEW was running at a still-robust pace of nearly $1 trillion, annualized. In the recession scenario, as MEW fades with the housing market, so too will consumer spending and the broader economy.

Inflation scenario

Those arguing that even more monetary tightening is needed dismiss the seemingly dark message in the inverted yield curve and the dire predictions for the housing market and its subsequent effects on consumers. They also believe that inflation will accelerate further and be stubbornly persistent. The Federal Reserve will either be vigilant in coming months and raise rates, or hold steady now and eventually be forced to tighten even more aggressively at the risk of throwing the economy into recession.

The economic message in the inverted yield curve does appear muddled. Global investors, flush with dollars generated by the outsized US current account deficit, have been avid buyers of long-term bonds. Many, including those from Asia, South America and Eastern Europe, have only recently come into dollars, and have been willing to trade higher yields for the safety and liquidity of the US bond market. They are investing for reasons largely independent of the US economic and monetary policy outlook. The inverted curve may thus presage slower growth, but not recession.

In the inflation scenario, high and persistent inflation remains the predominant concern. This worry took on added credence with recent upward revisions to measured unit labor costs. Before the revisions, labor costs appeared low and tame; after the revisions they now appear high and accelerating. When combined with a steadily falling dollar, near-record high prices for energy goods and other commodities and upwardly drifting inflation expectations, the inflation backdrop has turned decidedly less positive.

The Federal Reserve may pause at the next FOMC meeting or two, but will resume tightening later this year in an effort to alleviate developing inflationary pressures. Moreover, the longer policymakers wait to act, the more inflation will accelerate, eventually forcing even more tightening, raising the odds of a policy misstep and eventual recession.

Midcycle scenario

Moody’s Economy.com’s near-term economic outlook is more sanguine. The economy is thought to be in the midst of a mid-business cycle transition. The sources of growth are shifting away from interest rate-sensitive housing and MEW-driven consumer spending, and toward more balanced global trade and business investment. As in cycles past, the economy will struggle as this handoff occurs, but with some deft policymaking it will avoid recession. Indeed, the probability of recession in the coming year is only about one-in-four, and the probability of runaway inflation inducing even more tightening and a downturn later is even lower.

The housing correction is serious, but has been orderly so far and is expected to remain so. The downturn that began just over a year ago has another year to run, with the worst of the contractions in home construction and house prices yet to come. With first-time homebuyers locked out of the market given the collapse in affordability, and short-term investors running for the doors given the shift in market psychology, activity in previously juiced-up markets in the Northeast, Florida, Mountain West and California is sure to weaken substantially further.

The negative housing wealth effects will be substantial and have not yet made themselves felt, but higherincome and wealthier consumers, those who do the bulk of the buying, will remain stalwart spenders. MEW has empowered lower and lower-middle income households to spend more aggressively in response to their previously fast-rising housing values compared to times past. The sharp decline and now negative saving rate are testament to this. For upper-income households who have long had access to all types of credit, however, MEW has not impacted their spending response to changing housing wealth. As MEW fades, lower-income households will turn more circumspect, but upper-income households will be unfazed.

Flush businesses operating close to flat-out appear set to look through the domestic slowdown and will continue to invest aggressively. Recent capital goods orders are consistent with continued near double-digit growth in real investment. Even more encouraging is that investment is expanding across a wide range of equipment, software and structures. Outlays on aircraft, to energy-related equipment and structures, to office buildings are posting healthy gains.

In the midcycle scenario underlying inflation accelerates a bit further in the coming months, but moderates next year in response to below-trend economic growth. Labor costs will not intensify, and pressure on measured housing inflation from quickly rising apartment rents will level off. Prospects that energy and other commodity prices have peaked and that inflation expectations remain tethered add to the optimism that inflation will remain largely contained.

Outlook

More explicitly, Moody’s Economy.com expects growth that is just below the economy’s real GDP growth potential of 3% through this time next year. The unemployment rate will edge higher during this period, rising to over 5% by next spring. This will be sufficient to ensure that underlying inflation will peak in early 2007, with core CPI inflation topping out at 3%, and moderate by this time next year.

While this is above policymakers’ inflation target, the below potential economy will forestall further monetary tightening, and indeed odds are that some modest easing will be necessary next spring and summer. The economy’s performance will thus be somewhat uncomfortable as it makes a midcycle transition, but it will avoid both the pain of recession and the angst of accelerating inflation and even more monetary tightening.

For further information:
E-mail: help@economy.com
Website: www.dismal.com

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