Despite Positive First Quarter, Odds of 2008 Recession Are Still Above 50%

The Commerce Department this morning revised upward its estimate of first quarter growth in real GDP to 0.9% (precisely in line with the expectations of economic forecasters).

As a member of the Business Cycle Dating Committee of the NBER, I am asked frequently if the country is about to enter a recession, or if we have already done so. I cannot speak for the Committee, and I am not a professional forecaster. But I can give my views, for what they are worth.

It is hard to say that we entered a recession in the early part of the year, without a single negative growth quarter, let alone two of them. Even so, three minor qualifications to that 0.9% remain:
1) The number will be revised again, and could move in either direction.
2) A bit of the measured growth consisted of an increased rate of inventory investment, which was almost certainly not desired by firms and is likely to reverse later in the year.
3) As Martin Feldstein has pointed out, the QI growth number is defined as the change for the quarter as a whole relative to QIV of 2007; within QI, the information currently available suggests that GDP fell from January to February to March.

The reason why many suspected a QI turning point in the first place is employment, which is virtually as important an indicator to the NBER BCDC as is GDP. Jobs have been lost each month since January. Total hours worked is my personal favorite, because in addition to employment it captures the length of the workweek, which firms tend to cut before they lay off workers. This indicator too has been falling.

And of course there are the longer run indicators that have been very worrisome for almost a year: depressed household balance sheets, mortgage defaults, high oil prices, low consumer confidence, etc.

The economy is a four-engine airplane flying at stall speed, skimming along the top of the waves without yet going down. Real gross domestic purchases increased only 0.1 percent in the first quarter — almost as flat as you can get. But net exports provided an important source of demand for US products, and are likely to remain a positive engine of growth in the future. The same is true of the fiscal policy engine, as consumers receive and spend their tax cuts in the 2nd and 3rd quarters. On the other wing, the investment engine has been knocked out; inventory investment is likely to fall and residential construction will remain negative for sometime. The big question mark is the consumption engine. Is the long-spending American household taking a hard look at its diminished net worth and taking steps to raise its saving rate above the very low levels of recent years? If so, a recession will ensue.

We are already clearly in a “growth recession.” All in all, I put the odds of an outright recession sometime this year at greater than 50%. That number is meant to add together:
(1) the odds that it will turn out that we have already passed the turning point and
(2) the odds that the sharp recent expansions in monetary and fiscal policy will succeed in postponing the recession, but only until later in the year.
Come the fall, if demand starts to slow, I can’t see either the Fed delivering a second big dose of interest rate cuts (as they were able to in the 2001 recession, when the dollar was strong and inflation under control), nor the government delivering a second big dose of tax cuts (as they could in the 2001 recession, when the budget outlook was strong and debt under control).

Fed Modesty Regarding Its Role in High Commodity Prices

Fed Vice Chairman Donald L. Kohn in a speech yesterday, addressed a theory to which I am partial: the theory that low real interest rates have been a factor behind the continued rise in prices of agricultural and mineral commodities, including oil, over the last year.

The relevant excerpt: “Some observers have questioned whether the news on fundamentals affecting supply and demand in commodities markets has been sufficient to justify the sharp price increases in recent months. Some of these commentators have cited the actions of the Federal Reserve in reducing interest rates as an important consideration boosting commodity prices. To be sure, commodity prices did rise as interest rates fell. However, for many commodities, inventories have fallen to all-time lows, a development that casts doubt on the premise that speculative demand boosted by low interest rates has pushed prices above levels that would be consistent with the fundamentals of supply and demand. As interest rates in the United States fell relative to those abroad, the dollar declined, which could have boosted the prices of commodities commonly priced in dollars by reducing their cost in terms of other currencies, hence raising the amount demanded by people using those currencies. But the prices of commodities have risen substantially in terms of all currencies, not just the dollar. In sum, lower interest rates and the reduced foreign exchange value of the dollar may have played a role in the rise in the prices of oil and other commodities, but it probably has been a small one.” (Speech at the National Conference on Public Employee Retirement Systems, New Orleans, Louisiana, May 20, 2008).

As real interest rates have come down over the last year, real commodity prices have accelerated upward despite declining economic growth. (See graph, where the commodity price has been inverted so that one can see the correlation visually.)

Real interest rate and (inverted) commodity prices, 2007-08

The effect of interest rates can be demonstrated both theoretically and empirically. I have argued that the effect can come through any of three channels: inventories, production, and financial speculation.

Historically, real interest rates have had an inverse effect on oil inventories (when controlling econometrically for three other relevant factors). Nevertheless, I have to admit that inventory levels have not over the last year risen in a way that would support the theory. I thus have to rely more on the other channels of transmission to explain recent developments.

Stocks of oil held in deposits underground dwarf those held in inventories above-ground, and the decision how much to produce is subject to the same calculations trading off interest rates against expected future appreciation as apply to inventories. (The classic reference is Hotelling’s Rule.)

Apparently the Saudis have indeed deliberately decided to leave theirs in the ground. “King Abdullah, the country’s ruler, put it more bluntly: “I keep no secret from you that, when there were some new finds, I told them, ‘No, leave it in the ground, with grace from God, our children need it’.’’ FT 5/19/08. I see the interest rate as part of the Saudis’ decision how much oil to pump. Because the current rate of return on financial assets is abnormally low, they can do better by saving the oil for the future than by selling it today and investing the proceeds. Holding back production raises today’s oil price, to a point where the expected future return on oil has fallen to the same level as the interest rate. Hence the inverse effect of real interest rates on real oil prices. The same logic governs others’ decisions regarding how much copper to mine, how much forest to log, etc.

In addition to the link from world real interest rates to world real commodity prices, there is the less novel link from individual countries’ real interest rates to commodity prices expressed in their own currencies, a link that primarily passes through their exchange rates. For almost all of the eight floating-rate countries that I tested, both the US real interest rate and the local real interest rate (as a differential relative to the US rate) simultaneously had significant effects on real commodity prices. The effect is equally applicable to the United States: When the Fed eases and the dollar depreciates, the price of oil in dollars goes up quickly. This despite what many have thought in the past, that there is little effect because oil is invoiced in dollars.

White House Confidence that US is Not in Recession is Misplaced

White House CEA Chairman Ed Lazear expressed confidence to the Wall Street Journal today that the country is not in recession.   I, like Menzie Chinn, am surprised that Lazear is willing to put his reputation on the line in this way.  

It is true that the Commerce Department BEA’s advanced estimate of first-quarter GDP growth was still above zero (+0.6%).     But there are three reasons not to take this number too seriously.
(1) Revisions in these numbers are usually substantial, so the final number could easily turn out to be negative — or twice as high.
(2) Even if the +0.6% number were to hold up, it can be entirely accounted for by measured inventory investment.   In other words, real final demand fell rather than rose in the first quarter.   It is plain that this inventory accumulation was not the outcome of deliberate decisions by bullish firms to add to their inventories in anticipation of a booming economy.   Rather it was almost certainly unintended inventory accumulation, as goods sat unsold on store shelves and in warehouses.    This overhang makes it more likely that inventory accumulation will be negative in the 2nd quarter.   (Admittedly, rising exports from the weak dollar and rising consumption from the tax rebate checks could outweigh that particular factor, and we could scrape along the ground for another quarter at near-zero growth).
(3) As Martin Feldstein has been pointing out (e.g., in the FT), it is a misinterpretation of the GDP statistics to say that growth remained positive in the first quarter.  Rather GDP for QI as a whole was estimated to have been 0.6% higher as compared to QIV as a whole.  The Commerce Department does not report monthly GDP estimates, but MacroAdvisers does, and these data suggest that monthly GDP has been declining since January.

There are other reasons as well to consider it likely that a recession may have started as early as January.     The NBER Business Cycle Dating Committee, which declares when recessions start, looks at lots of data.  But the most important information, alongside GDP, is the jobs data from the Bureau of Labor Statistics.   Employment, like GDP, offers a comprehensive measure across the economy, but it has the advantage of being available monthly and with shorter lags.    The employment data suggest that the recession may have started in January.

It is certainly possible that it will turn out, in the end, that the economy escaped recession in the first quarter.   Even if that is the case, however, it is difficult to be optimistic about the rest of the year.   I can’t remember a time when there have been so many worrisome danger signals:   depressed household balance sheets, mortgage defaults, high oil prices, low consumer confidence, … . The odds of a recession sometime this year must be rated high.

Fed Chairman Bernanke and Treasury Secretary Paulson have wisely reined in the “happy talk” with which the initial sub-prime mortgage crisis was greeted last  year.   (Remember “the crisis looks contained”?)    If I were Ed Lazear, I would follow their lead.

How Far the NYT Had to Go to Find an Economist to Support the Gas Tax Holiday

Economists frequently complain that even when 98% of the profession agrees on something (say a free-trade proposition), the media will go to lengths to dig up an economist from the 2% minority in order to balance one from the 98% majority, in their feverish and misguided attempt to appear unbiased and balanced on every issue, even issues that don’t really have two sides. The New York Times op-ed page has outdone itself today by publishing “The 18-cent Solution” by Bryan Caplan. The “callout” heading is “Found: an economist who backs the summer gas-tax holiday.” The impetus, of course, was the question posed to Hillary Clinton by a reporter: can you name a single economist who supports the idea of a summer suspension of the federal gasoline tax? Newshour gave up on trying to find one.

In this case, the NYT evidently couldn’t find an economist who really takes the minority position on economic grounds, or even on reasonable political economy grounds. (The profession is all-but-unanimous on keeping the gas tax, as Greg Mankiw notes. And for good reasons.) Rather Caplan’s argument is a convoluted political rationalization: (1) the high gas prices engender populist anger that might lead to bad policies, (2) yes, a gas tax holiday is a bad policy, but (3) one can make a political argument for the gas tax holiday because it is not as bad as some of the other “populist nonsense: price controls, rationing, windfall profits taxes…” that we might get instead. This political argument is a bit of a stretch as it is, but he then goes on to make it absurd by supporting “a pairing of an excess profits tax with a gas tax holiday” on the grounds that it is not as bad as “an excess profits tax all by itself.” Apparently two bad policies are better than none.

This sort of reasoning makes me sympathize with political scientists who tell economists to leave the politics to them. A more straightforward political argument would have been “Hillary is the best candidate and so one can justify anything that will get her nominated.” Or the symmetric argument for John McCain, who originally proposed the gas tax holiday in April. But the New York Times editors, sensibly, would not have chosen to print such op-eds, out of the hundreds that are submitted every week. So they printed instead an economist’s political argument too complicated for them to understand. If they are going to do this, they might as well print economists’ economic arguments too complicated for them to understand, which they are seldom willing to do.

Bryan Caplan is a perfectly competent economist, with a Ph.D., a job and an interesting book and everything. (He may be a bit too desperate for publicity. But those of us who live in glass weblogs can’t throw stones.) Why would he spout the nonsense that is in this op-ed? The answer is very clear: it is the way to get into the New York Times. He gleefully admits as much on his blog today: “I’ve finally made the Gray Lady: Today’s New York Times features my op-ed inspired by Sunday’s post, I’ll Shill for Hillary. I hope critics don’t misrepresent me as an economic apostate; I’m not dissenting from the standard analysis… look on the bright side: I’m in the New York Times. Sweet!”

Bryan: A suggestion. You should now write a letter to the New York Times retracting your op-ed on the grounds that you should have known that readers would incorrectly infer that you were supporting the policy on economic grounds. [Arnold, can you help out here?] If you do this, the Club of Economists might let you back in. Plus, you will have gotten your name in the NYT a second time! “Sweet!”