EconoMonitor

Nouriel Roubini's Global EconoMonitor

A Coming Recession in the U.S. Economy? Certainly There is Now a Much Higher Risk of One…

I have so far been somehow cautious in my bearish call for the U.S. economy. My pessimistic views have been far from the consensus of a 3.5% US growth moderating to 3% in H2: I have argued that the U.S. will slow down to an annualized growth rate of 2% by Q4 of this year. This is certainly a negative outlook for the U.S. and global economy (given my arguments against “decoupling”) and for the markets; but it was not a recession call. 

I am now revising my view by assigning a larger probability to a U.S. recession in 2007. Until now I believed that a growth recession – i.e. growth of 2% – was the most likely scenario for the U.S. next year. But recent developments suggest to me that the probablity of an outright recession – or a stagflation-lite where output actually drops rather than slows down – are now, in my subjective view, as high as 50%. So, I do not now predict with high probability a recession but now believe that its probability has significantly increaed to around 50%. This increased risk of a U.S. recession is the outcome of the aggravation of the Three Bear trends – and other vulnerabilities – that I have been worrying about since last fall: higher oil prices having a stagflationary effect; a housing slump negatively affecting residential investment and housing; and higher core inflation forcing the Fed to raise the Fed Funds rate to 6%.

What has made these risks and vulnerabilities more serious now is the aggravated geopolitical environment (North Korea, Iran and now the severe conflict between Israel and Palestinians and Lebanon) that will make the stagflationary effects of high oil prices more severe and will make the negative effects of such geopolitical shocks on consumer and business confidence and markets more severe.  I had indeed predicted that oil would – at some point – go above $80 and even reach $100. But this was a medium-term prediction: now oil at $80 – and staying at those levels for a while – is a meaningful likelihood. And, as argued before, oil at $80 will have serious stagflationary effects differently from the effects of oil prices in 2004-5 (when rates were lower and housing perky while now you got a triple whammy). High oil prices will reduce both confidence and incomes for cash-strapped saving-less US consumers with falling real wages and rising debt and debt- servicing burdens. And it will lead to some increase in both headline and core inflation that will force the Fed to tigthen all the way to 6% by February 2007 (even if, after a hike in August, some pause may occur between then and the hike to 6% by early 2007). And, all indicators from the housing markets suggest an increasing slump in this crucial sector. I now predict that real residential investment will fall at an annualized rate of 7% for the next 4 quarters. This will be a direct negative drag on growth and, via wealth effects and sharply reduced mortage equity withdrawal,  willl be a further drag on real consumption growth. 

So, if oil goes above $80 and closer to $85 for a persistent period while geopolitical risks increase further (i.e. Iran does not start to seriously negotiate on its nuclear proliferation, the tensions with North Korea significantly increase, the conflict between Israel and Hezbollah turns into a full fledged war that gets Syria – and possibly Iran – directly involved in the conflict; these are all serious possibilities now), I would assign a 80% probability to a U.S. and global recession. But even with oil only closer to $80  (in the $75-80 range) and the geopolitical risks remaining at the current levels – rather than escalating substantially more – I now assign at least a 50% probability to a U.S. recession in 2007.

The fact that even the most authoritative publications (see the WSJ on Saturday) are now openly talking  – in long front page articles – about the greater risks of a U.S. recession; the fact that even a study by the Federal Reserve economist Jonathan Wright now puts the probability of a US recession as high as 36% (up from 14% in January); the fact that many others are now discussing this recession risk (see here and here and here) should be a warning to markets and investors that their so-far wishful thinking or hope that the recent turmoil would be temporary may now be seriously dashed by the facts.  The risks of a U.S. recession are now seriously increasing and the burden of proof, at this point, is now on the Panglossians who still believe that the U.S. can absorb all the shocks that are buffeting it with limited growth effects. So, I look forward to hearing sensible arguments on why Goldilocks will successfully repel the Three Ugly Angry Bears.

For all the details of my recent views on the risks of a U.S. and global slowdown and the risks of further turmoil in emerging markets, subscribers to RGE’s Premium Content may want to look at my recent writings, conference call, video webcasts (here and here) and powerpoint presentations (here and here).

 You can also view for free my video interview today on Forbes.com where I comment on the PPI report, inflation, the Fed, oil and the risks of a stagflationary outcome for the US economy.

 

36 Responses to “A Coming Recession in the U.S. Economy? Certainly There is Now a Much Higher Risk of One…”

AnonymousJuly 18th, 2006 at 3:45 am

There are of course major risks ahead of us. I just don’t see Bernanke, and other Central Banks for that matter, behaving so stupidly as you seem to anticipate.

AnonymousJuly 18th, 2006 at 3:45 am

There are of course major risks ahead of us. I just don’t see Bernanke, and other Central Banks for that matter, behaving so stupidly as you seem to anticipate.

NourielJuly 18th, 2006 at 11:55 am

I do not believe that Bernanke and other central banks will behave stupidly. I have argued that, with inflationary pressures rising (see for example the bad PPI inflation report today), they will be forced to keep on rising interest rates.

GuestJuly 18th, 2006 at 1:03 pm

But won’t a pending recession or significant slowing in growth moderate oil prices? If you believe that the current price of oil is based on fundamentals (motly), then the answer is that yes, that should bring down prices significantly if demand is reduced in the US as a result of a recession. I have two issues with that thought, the first that I think we’d have to have a depression to reduce gas demand in the US in any meaningful way. Secondly, I do not think the current price of oil is at all linked to fundamentals any longer. I think that even if Iran stops enriching today, there is peace in the middle east and nigeria, that the speculators will find a way to keep the price high. Call me a conspiracy theorist, but when the price of gas shoots up because Americans used more gas onthe 4th holiday from a level that was high because Americans were expected to use more gas in the summer driving season, every sneeze is an excuse to drive the price higher. It was only a few motnhs ago that we were at $60, and for two years now people have been fretting about supply disruptions that have never happened. Well, Katrina was about as big as it gets, and look how well it was handled. It’s all an excuse.

GuestJuly 18th, 2006 at 1:09 pm

Well, OK Katrina isn’t as big as it gets, but the lesson there is that all the stockpiles around the world and the international response can compensate for even a medium-term disruption. Oil should be about $45-$55 a barrel right now.

RS-KJuly 18th, 2006 at 1:35 pm

Anonymous,  Nobody (not even a central banker) intentionally behaves stupidly. But central bankers do make mistakes and misjudge the consequences of their actions or inaction. Imagine going back to the mid-1970s and asking central bankers if they intend to generate steadily-rising inflation over the next 5-7 years. What do you think their response would be? I’d bet that it would be a resounding “no”. They would likely respond that what they were doing is smoothing output in response to a temporary aggregate supply shock. And they would comfort us all by reassuring us that, “don’t worry, we really know what we are doing”. Of course, things didn’t exactly turn out the way they planned it.  What happened? Well the central bankers were looking at their projections and assumed that productivity growth would just “keep on trucking” along. It didn’t; real output growth slowed, aggregate demand outstripped poential and we were on an inflationary spiral.  I think that we have to be careful that we don’t miss a similar paradgim shift today. There are two issues/risks here:  First, will productivity growth continue unabated or will higher oil prices induce signficant restructuring that will pay off in the medium term, but impose some real costs in the short term. Adjustment is not costless, regardless of its long-term beenfits.  Second, is the sum of the parts greater than the whole? Will the combined effect of central bank tightening (appropriate for each individual country) create a negative externality that imposes an additional (unintended) effect that enhances the potency of individual moves?  I don’t know the answers to these questions. But I get the feeling that we are going to find out. 

GuestJuly 18th, 2006 at 5:41 pm

@Anonymous:  Am I supposed to understand your post? Why are you surprised to be censored if you go around dissing like that?   need a DOCTOR?

NourielJuly 18th, 2006 at 6:07 pm

Guest: i did indeed delete again the rude comments of the @Anonymous commentator that is continuously providing insulting comments towards me. I do not mind even sharp critiques of the substance of my view; i am open to any constructive dialogue on any view. But I will not tolerate any vulgar insults towards me or any other participant of this blog. This is a place for civilized and intelligent discussion, not insults. Thanks to all of you who contribute to this interesting dialogue. Nouriel 

NourielJuly 18th, 2006 at 6:14 pm

RS-K: thanks for your thoughtful points. Central bank do indeed make mistakes from time to time: they are especially likely to overreact if they did underreact earlier, in this case by letting asset bubbles to fester for too long.  On productivity growth i am cautious as potential productivity growth is likely to be closer to 2.5%-2.75% than the 3.5-4.0% range of the last few years; Robert Gordon has argued that the last few years of high productivity were driven by one-off cost cuts that are not permanently sustainable.   On your second point, there is indeed the risk that uncoordinated monetary policies will lead, in the aggregate, to more tigthening than desirable. Indeed both G7 and emerging market economies are now on a tigthening path. 

CharlieJuly 19th, 2006 at 10:57 am

I think the only way the fed will tighten to 6% is if the other major central banks tighten by a similar amount. I don’t see Europe or Japan tigheting by another 0.75%. I suspect the Fed will pause at 5.5% for a while and only if the economy continues to chug along, will it consider further rate hikes.  I tend to agree that the price of oil is being partially inflated by speculators, but, there would have to be a downward force on oil prices to cause the unwinding that would ultimately drop oil to below $60. Something like a dramatic drop in demand or a dramatic increase in supply. Right now, I don’t see how this would occur. Maybe in a few years, ethanol usage will be more widespread.

NourielJuly 19th, 2006 at 11:06 am

After yesterday’s PPI report and today’s CPI report, both showing surging headline and core inflation, the Fed will not only go to 5.5% in August but it will be forced, because of persistently high inflation in the months to come, to go all the way to 6%. Nouriel  

DFJuly 19th, 2006 at 11:22 am

the Fed will not only go to 5.5% in August but it will be forced, because of persistently high inflation in the months to come, to go all the way to 6%.  Nouriel    Nouriel you are suggesting that the FED is stupid enough to go on fighting the wrong war on the wrong ennemy with the wrong tools ?   Why fight this last current inflation blip when all signs point to a major deflation ahead once the recession takes hold ?   The housing bubble is bursting worldwide, WORLDWIDE, consumers will disappear and this will bring all price down, especially commodities and energy as Asia will be forced to stop to invest massively because of slowing export revenues and falling margins.   why the hell care about inflation ?   Inflation is what we need, not what we’re afraid off ! How are we going to pay back our debts in nominal terms if there is no inflation to bail us out ?  The consumer and the government will never be able to pay its debt at current real levels. Everybody knows that, so inflation is what we need. WHy is not the FED publicly endorsing a goal of inflation at around 10% by doing so it might reduce the deflation risk. Why is not it printing money and ginving it to the government instead of lending it to banks ?   Why is there no whistle blower on the huge debt load ? Why is no new Keynes coming to the mike and saying : sorrry folks, debts will be repaid through inflation, that’s the only way they ever will be repaid at all.   I’m amazed that a few months of inflation over 3% (good brief, not even 5!!) is scaring the hell of all economists, when the years ahead of deflation do not seem to scare anyone.   IS there no one convinced that deflation is a 100% sure thing ? How is inflation going to happen once the debt burden starts to fall (at least relative to GDP) ? And how can anyone believe that the world debt can rise forever with a debt/GDP ratio reaching infinitum ? Come on, 60 years of inflation are no guarantee over a major debt deflation crisis and it has never been so near now that the world housing bubble is over.  

RS-KJuly 19th, 2006 at 1:08 pm

DF,  Interesting point. Inflation can be a useful coordinating mechanism to promote the real-side adjustments (real wages, real interest rates, etc.) needed to move an economy out of great depression. (Keynes argued that nobody accepts a nominal wage reduction unless everybody else accepts the same reduction. In contrast, real wages can be reduced through unexpected inflation quickly and relatively costlessly.) Yet, the experience of the 1970s shows the costs of sustained inflation (largely in terms of distoring savings/investment decisions). Moreover, deflation, while possible, is not certain.  So, the Fed’s dilemma is whether to act to reduce the risk of a bad outcome (deflation) that has some probability, recognizing that doing so will result in an almost certain insiduous weakening of the price mechanism.  Obviously, the Fed would like to navigate between the two and deliver on its dual mandate of low inflation and steady growth. The problem is that it, like everyone else, is in the cave trying to discern the meaning of the shadows reflected and distorted on the walls. 

AnonymousJuly 19th, 2006 at 1:51 pm

Prof. Roubini, Interesting that BB is so dovish in the testimony. Any comments on that?

AnonymousJuly 19th, 2006 at 1:51 pm

Prof. Roubini, Interesting that BB is so dovish in the testimony. Any comments on that?

CharlieJuly 19th, 2006 at 2:07 pm

High inflation will lead to high interest rates. I don’t think we want a return to the late 70′s and early 80′s. High inflation and high interest rates isn’t pretty.

DFJuly 20th, 2006 at 4:13 am

Yet, the experience of the 1970s shows the costs of sustained inflation  If you talk of the 70′s you talk about relatively close economies with strong unions, highly regulated markets and little information technology.   Which of this condition is true now ?  Conclusion, the inflation of the 70′s was caused by wages moving faster than productivity due to strong unions (and other conditions) now we have a commodity based inflation due to overinvestment in asia due to globalisation. Once the western consumer stop to buy the asian products because they’ll stop to borrow, then we’ll have a major world overcapacity problem. And will that one be managed ?   Deflation is not a possibility deflation is the 100% guaranted conclusion of all credit led booms. Endogeneous money supply has risen, hence we’ve had some inflation, especially in asset prices, credit expansion has gone excessive, a correction is due, hence deflation is ahead, unless a very strong intervention from the fed replaces the endogeneous money destroyed by bankrupties by exogeneous money supply.

GuestJuly 21st, 2006 at 6:20 am

klop6.info  Which of this condition is true now ?  Conclusion, the inflation of the 70′s was caused by wages moving faster than  productivity due to strong unions (and other conditions) now we have a commodity based inflation due to overinvestment in asia due to globalisation. Once the western consumer stop to buy the asian products because they’ll stop to borrow, then we’ll have a major world overcapacity problem. And will that one be managed ?  klop6.info 

RobertJuly 21st, 2006 at 8:50 am

Great piece. Can I just check, are you sure Jonathan Wright’s model puts the probability up at 36%, from 14% in January? Which one of his models does this, because my own implementation of his preferred model (Model B in the paper, for a 4 quarter horizon) only puts it around 25% currently, which is only a little above the unconditional mean. In fact using my calibrated model suggests that to obtain a probability of 36% we would (roughly) need to see the 3m-10y invert to -40 with a current fed funds, or with the current inversion (around 6 bps) we would need to see the fed funds go to 6.5. I’d be grateful for any thoughts you or others might have.

DFJuly 22nd, 2006 at 2:29 am

Nouriel :   klop6.info   is a spam. (I was wondering who was quoting me and why … and it’s an ad :-(    

DFJuly 22nd, 2006 at 2:29 am

Nouriel :   klop6.info   is a spam. (I was wondering who was quoting me and why … and it’s an ad :-(    

SkoobzJuly 23rd, 2006 at 2:45 am

Here here, DF, HERE HERE! You must feel like I do…that deflation scenario is a the most likely, and the inflation concerns are completely ridiculous.  ”The housing bubble is bursting worldwide, WORLDWIDE, consumers will disappear and this will bring all price down, especially commodities and energy as Asia will be forced to stop to invest massively because of slowing export revenues and falling margins.”  here, here.

SkoobzJuly 23rd, 2006 at 2:59 am

“IS there no one convinced that deflation is a 100% sure thing ?”  I am convinced. It’s a lay-up, in my opinion. I believe economists dismiss the deflation argument because it’s not in the papers now, it attracts no attention. Economist try to pin their name to whatever’s hot, and right now that happens to be inflation , oil and immigration. How can you be quoted in the New York Times or Forbes if you’re talking about debt loads and deflation when all the readers are concerned about other economic issues? How can you be relevant if you’re not quoted in the New York Times?

AnonymousJuly 23rd, 2006 at 6:41 pm

I agree broadly with you but for slightly different reasons. I do not think the oil price is high because of speculation – it is high because it is scarce. Oil geologists like Kevin Campbell have been saying for some time that peak production will happen about now. Exploration will discover more oil but in more difficult areas and in smaller amounts. Oil shale requires processing that itself uses energy. The limiting factor is now the Energy Return on Energy Invested (EREI) not the total of capital thrown at the quest. Cheap oil is really gone forever, bar a deep global recession; which is unfortunately, the eventual end point of BAU as the entire economy is so dependant on the black stuff. And nuclear is not he easy answer either. Price inflation arising from high oil prices should be allowed work its way through the system – it is inflation, yes, but not of the self fulfilling prophesy kind. It is the necessary adjustment-to-an-oil-scarce-world-kind. Bernanke should hold the rates rises and the US government should think of another way of controlling property asset inflation which in contrast to above, is the old fashioned downright dangerous kind of inflation. Why not increase site value taxes? You have them in some cities under the title ‘dual rate tax’. Land taxes are the “ least worst taxes’ according Milton Freidman; they are the only form of taxes that actually encourages enterprise and investment. I know this needs cooperation from the States, as property taxes are not part of the federal remit. Check out Wikipedia for more on land taxes. But can you think of a better way to gently deflate the property market without damaging the making and trading economy? As for the US dollar, it is in for the long drop any which way it turns ever since it lost its hegemony on oil sales. Might as well just get it over and done with.  

GuestJuly 27th, 2006 at 5:23 am

DF,  The Asian crisis in 1997-8 is testimony that not all cedit led booms end in deflation. Given the situation with the US$, surely there is a fair probability that deflation might not occur in the US at least and the brunt of any bursting of the “bubble”, if such exists, might be taken by a depreciating currency.

VintermannJuly 28th, 2006 at 1:16 am

“Oil should be about $45-$55 a barrel right now. ” … because of stockpiles, say Guest. Well, since it isn’t, that means the owners of those stockpiles think the prices won’t go down to $45-$55 in the medium term, even, doesn’t it? Seems that way to me when I look at the futures…  I do believe the oil price is based on fundamentals… Cantarell and the North Sea are in _serious_ depletion. it won’t be easy to bring alternatives on line fast enough to compensate.

SkoobzAugust 3rd, 2006 at 12:07 am

“The Asian crisis in 1997-8 is testimony that not all cedit led booms end in deflation. Given the situation with the US$, surely there is a fair probability that deflation might not occur in the US at least and the brunt of any bursting of the “bubble”, if such exists, might be taken by a depreciating currency. “  are you kidding? asian crisis…thailand and korea…deflation and currency crisis.

GuestAugust 3rd, 2006 at 3:01 am

Skoobz,  are you kidding? asian crisis…thailand and korea…deflation and currency crisis.  I wrote: “The Asian crisis in 1997-8 is testimony that not *ALL* cedit led booms end in deflation.”  While some Asia countries experienced deflation after the crisis, others like Indonesia continued to have high inflation while the currency collapsed. 

GuestAugust 7th, 2006 at 1:14 am

As to the last comment . . . can you explain further the Indonesia situation? Why did it not suffer deflation as the others did? Are there parallels to the current US situation?  My readings (“The Dollar Crisis” for one) have also indicated that credit booms inevitably end in deflation. But I have had a hard time reconciling what I expect to be continuing inflation throughout the US economy, with the thesis of ‘inevitable’ deflation from a credit overhang. While I do expect housing to decline in prices, I believe there are many factors pushing other prices up enough to greatly outweigh the coming housing ‘adjustment’.  In essence, I have been trying to marry a domestic inflation scenario with a global deflation scenario and have not been able to get a handle on it. How can this occur?  I accept as a given that the dollar is going to depreciate substantially. Is that all that is needed . . . for a massive dollar hit to take all the pain?

GuestSeptember 10th, 2006 at 5:34 pm

As long as China and India are producing cheap goods that US and other rich western nations can enjoy at low price, there is no risk of worldwide inflation. Deflation is also ruled out because BRIC will keep growing because they are investment economy not consumer economy. The housing inventory will vanish once sellers realize they need to reduce price to attract buyers. At today’s low interest rate there are sufficient buyers to afford homes. This is not yet like 1970′s

Most Read | Featured | Popular

Blogger Spotlight

Dan Steinbock

Dr Dan Steinbock is a recognized expert of the multipolar world. He focuses on international business, international relations, investment and risk among the major advanced economies (G7) and large emerging economies (BRICS and beyond). In addition to his advisory activities (www.differencegroup.net), he is affiliated with major US universities as well as international think-tanks, such as India China and America Institute (USA), Shanghai Institutes for International Studies (China) and EU Center (Singapore).

Economics Blog Aggregator

Our favorite economics blogs aggregated.