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2006 Economic Outlook Roundtable:
Scenarios for the Next U.S. Recession

Presentation of Kathleen Camilli, Chief Economist and Director, Camilli Economics

MS. CAMILLI: Good morning, everyone. It's a pleasure and an honor to be invited to the FDIC to give a presentation on the economic outlook.

I just want to start out with a little commercial and tell you a little bit about what I do. This is a mission statement for the firm. The mission of Camilli Economics is to deliver insightful economic analysis to our clients and to teach people about the workings of the economy so that they may live prosperously and fulfilled.

And just a little quote from John Kenneth Galbraith before we start. It's important to remember, when economists are asked to forecast, they divide themselves into two camps: those who don't know, and those who don't know that they don't know.


I prefer to think of myself as the former. So I want to start out with that.

I would concur with Rich that your bigger problem is probably with exogenous shocks and external factors that might affect a banking system, rather than with an outright recession. What you're looking at right here is a spread between the 3-month T-bill and the 10-year note (see Chart 7). And when people ask me, "Well, when do you think the next recession will be?" I always tell them, "Well, probably 2010."

Chart 7

Chart 7 Spread between 3-month T-bill and 10-year note.d

Why? Because we've tended to have recessions that coincide with the political presidential cycle, and they tend to be around the turn of the decade. So we had one in 1970 and '80 and '90 and 2000 and 2001, and we'll probably have one in 2010.

I think probably what's of greater interest to all of us right now is whether we're going to have a mid-cycle growth recession. Certainly, that's what I'm being asked and what I'm focusing on.

And I think that the evidence to date is inconclusive. It looks like fourth quarter GDP may be our weakest quarter last year, and maybe when we look back we will determine that that was our mid-cycle growth recession. We'll see as the slides go on.

I think that probably your greater worry is what's going on within the banking system. Chairman Greenspan has, starting with the annual conference at Jackson Hole, been talking about the narrow risk premium in the markets, the narrow credit spreads, and how people are extrapolating into the future that asset values will continue to climb at the current rates.

So it appears much more likely that we'll be affected by something external rather than recession, as to affecting the banks.

And just to put this in perspective, it has been a while since we've had a shock. Going back through the 1990s, the IO-PO [interest-only–principal-only stripped mortgage-backed security] market debacle in 1994 was the last time we were in the middle of an economic expansion. When the Fed ended up overtightening, it had some ramifications on the market.

Then, of course, we had Long-Term Capital Management in 1997 and the 1998 episode that was sparked by the Russian debt default. And we had the unraveling of the NASDAQ in 2000, which had some repercussions on the financial system. And it has really been a while. It's been a few years. So from that perspective, just the perspective of probabilities, we're kind of overdue for something to happen. And I think that's the reason we've had a cautionary flag sent up by some policymakers.

With that said, our last two recessions have been relatively short and shallow, even leading some people to believe that the business cycle could be dismissed or has been rendered irrelevant. But I doubt that's the case, since we've had business cycles for hundreds of years.

So I'd like to draw your attention to this chart showing the yield curve spread (see Chart 8). The worry right now is that the inversion of the yield curve is somehow signaling a recession. And from my perspective, that couldn't be further from the truth. This particular yield curve, based on the spread between 2-year and 10-year maturities, is not yet inverted. But is has tended to invert before the last two downturns, and you can see it was pretty significantly below zero in 2000, and similarly in 1989.

Chart 8

Chart 8 Spread between 3-month T-bill and 10-year note.d

So from my perspective, we're nowhere near an outright downturn in the economy.

In this chart we've put that against GDP, just so you can see the mid-cycle growth slowdown (see Chart 9). We had one in 1986 when GDP growth dropped to roughly 1 percent, and we had one in 1995 when you had two back-to-back quarters of growth under 2 percent, in the first two quarters of 1995.

Chart 9

Chart 9 Federal Oen Market Committee: Fed Funds Target Rate. d

The question that I would pose is: Are we now going to have two soft quarters that could be characterized as our mid-cycle growth slowdown? I'm posing the question. I don't know the answer.

Of course, I always like to tell people who listen to my speeches that each and every economic expansion and each and every economic recession is unique, because the economy is never the same at any two points in time. It's dynamic, it's complex, and these elements are what makes the economy so fascinating to watch.

Now, of course, the Fed has been combating inflation, but really what they've been doing is moving the federal funds rate from an aberrantly low level of 1 percent up to where it currently is, around 4 ¼ percent.

And I put up here the target rate for the FOMC [Federal Open Market Committee], the federal funds target against CPI [Consumer Price Index], just so you can see that even back in 1995 they really weren't going after a perspective rise in inflation, even though commodity prices were rising. This time around you've got a combination of rising commodity prices, rising energy prices, and the Fed also wanted to just get the federal funds rate off of this very, very low level.

So last year I made a forecast that the Fed would stop tightening at around 3 ¾ percent. That forecast has been incorrect. They raised rates up to 4 ¼ percent, and the market is anticipating at least two more tightenings. The language from the most recent FOMC meeting suggests that there is a bit of uncertainty right now, and future policy will depend on the data that comes in.

From my perspective, I think that there is a possibility that they could pause here at the FOMC meeting at the end of the month, and maybe not signal that they've stopped, but maybe signal that they paused, just so that they could wait to see the impact of their efforts over the last year.

Again, [Chart 10] is a picture of the federal funds rates and The Journal of Commerce and Industrial Price Index, just to show you that, really, back in 1994 what they were worried about was rising commodity prices. And it was that reaction to rising commodity prices that really caused them to overtighten.

Chart 10

Chart 10 Federal Open Market Committee: Fed Funds Target Rate. d

So as I look at this graph, keeping in mind as we know that only about 10 percent of the price of a good is commodities, I really wonder whether the Fed isn't repeating the same error in overtightening as a reaction to commodity prices. That's my greatest concern, which is why I think they probably could have stopped earlier, but they have not.

[Chart 11] is a picture of the target rate once again, the federal funds rate versus home prices. And so we turn our discussion now to where the real inflation is that the Fed may be trying to combat. Instead of being in commodity prices, instead of being in energy prices specifically, or a worry about a rise in the overall price level, I think that probably what they're really after is what's going on with this little bubble in housing prices. I'll call it a little bubble, because I'm on record as saying that we don't have any broad-based bubble in the nation's housing stocks, but we have seen speculation in certain housing markets around the country. I guess Mr. McMahon is going to address that later. And as we know from Dr. Schiller up at Yale, speculation always ends badly.

Chart 11

Chart 11 Federal Open Market Committee: Fed Funds Target Rated

So my guess is that home prices—that is, the median price on existing homes—have already peaked and are starting to roll over. They are gradually coming down. That's judged from the level of inventory, of stock on the market. So my guess is that if they were just to leave policy here now for the remainder of this year, this would kind of untangle itself on its own, without them needing to do anything else.

Now, there's been a lot of talk about a housing bubble and the adverse impact that will unfold as the Federal Reserve tightens and housing starts to subside. But I really question that. We're going to look at some charts later on about overall wealth in the economy.

Again, [Chart 12] is a picture of the target rate for federal funds and the impact on consumption. You can see that we have had mid-cycle growth recessions in the last two decades, in 1986 and in 1995. We did temporarily have a dip in consumption in those episodes. You can see from the personal consumption numbers and the type of growth rates we've seen in this particular expansion that we've had no evidence of any dip in consumption yet.

Chart 12

Chart 12 Federal Open Market Committee: Fed Funds Target Rated

Again, when the fourth quarter GDP number comes out next week, we may see evidence that we're already in the midst of our mid-cycle growth recession. All of the numbers we've seen so far suggest that PCE [personal consumption expenditure] growth did subside in the fourth quarter.

My two favorite leading indicators—and, of course, Chairman Greenspan says that we can't use any single econometric model or any single indicator to predict the direction of the economy—but my two favorites happen to be the University of Michigan Consumer Expectations Index combined with the S&P 500. Those were the two indicators I used in the spring of 2000 and in December 2000 to call the beginning of the recession. Those two indicators don't indicate that any recession is pending in the near future at all (see Chart 13).

Chart 13

Chart 13 University of Michigan: Consumer Sentimentd

And this is the Economic Cycle Research Institute, Jeffrey Moore's Institute, and his leading index is also not signaling any imminent recession at hand (see Chart 14).

Chart 14

Chart 14 Economic Cycle Research Institute Weekly Leading Indexd

[In Chart 15] we have a picture of productivity and unit labor costs. And I really question whether, in fact, we are about to see some rise in unit labor costs, even though it has been widely proclaimed in the papers that what we need to see right now is a rise in unit labor costs, or will we see that as productivity subsiding.

Chart 15

Chart 15 Economic Cycle Research Institute Weekly Leading Index d

I completely question the thesis. I would concur with Dale Jorgenson up at Yale that we are moving into a period of capital deepening, and that the structural productivity rate in the economy is probably running at around 3 percent.

If that's the case, it means that our economy can grow on a sustained basis for the remainder of this decade at a rate of 3 to 4 percent. And I think that that's what we're looking at—barring exogenous shocks, of course.

And why don't I think that unit labor costs really have to rise here? Why will they just kind of muddle along around 2 ½ to 3 percent every year? Well, we have outsourcing, we have offshoring, we have all different kinds of ways for companies to make use of the technology that's at their disposal.

And this expansion has been unique in that the economy has been able to grow between 3 and 4 percent, but we haven't had what we should have had in terms of nonfarm payroll growth, which should be between 300,000 and 400,000 on average every month during this type of period (see Chart 16).

Chart 16

Chart 16 Nonfarm Business Sector: Output Per Hour/All Persons d

Instead, we have had average nonfarm payroll growth last year of about 166,000 per month. I don't suspect it will change this year or the next year, and that just has to do with different ways companies are dealing with the opening up of India and China, and what's at their disposal.

Also, I do think that there's probably some job growth that's occurring at small companies. There's been a lot of creation of start-up companies because of the Internet, and I'm not so sure how much that is being captured in the employment statistics. The unemployment rate seems to reflect that as it keeps going down. It has hit a low of about 4.9 percent, which hopefully is where it will stay for the remainder of the decade, or at least around that area (see Chart 17). I don't expect it will go down to 3.8 percent anytime soon.

Chart 17

Chart 17 Nonfarm Business Sector: Output Per Hour/All Personsd

But, again, I think the scenario for the rest of the decade is one of relatively strong growth, relatively low inflation, and relatively low short- and long-term interest rates. Really, you couldn't wish for a better economic environment, again barring exogenous shocks. And I think exogenous shocks are anyone's guess.

So, again, we have future productivity, nonfarm business productivity, and we have a picture here of real estate prices (see Chart 18). This is where I want to pause and talk a little bit about wealth. One of the reasons that I was successful in making that call in 1999 for Business Week is because I did take into account the impact of wealth; in particular, at that time it was the rise in stock prices and their impact on consumption.

Chart 18

Chart 18 Nonfarm Business Sector: Output Per Hour/All Persons d

And I think, similarly, the overall level of wealth that's in the housing stock, and its continued rise during this four-year period, is translating into a higher level of spending than there otherwise would be. Just take a look at how sharply the level of wealth in real estate has gone up just in the last four years, compared to the two decades prior to that. It was a gradual rise over the course of the 1980s, over the course of most of the '90s. Then, we hit the Internet boom, of course, a boom tied to innovation, which only happens about once every 70 years. Much of the wealth that was created during the Internet boom, much of which was maintained, went into real estate. So that is the cause for the acceleration in real estate prices in the latter half of the 1990s.

And then, of course, when we went into recession in 2001 and the Federal Reserve lowered interest rates, money came out of the equity market and moved to a different asset class. It moved to the real estate market. That's where it is now, because people want to get the highest rate of return on their money, and it was perceived that equities would no longer return double-digit rates. So people moved into real estate.

The rise in the value of the stock of real estate is just incredible, and I think it is having a big impact on consumption spending. So you would never find me forecasting a downturn in PCE, now or anytime soon, purely because of what happened to housing. Here I put PCE against housing wealth just to further drive home the point that consumption spending is not just being driven off of income, as in a traditional econometric model (see Chart 19). Much of it is being driven off of wealth in housing.

Chart 19

Chart 19 Real Personal Consumption Expenditures d

And I think that there's a reason that Greenspan focused on this in the paper that he co-authored with Mr. Kennedy that was released several months ago. The home is the primary vehicle for savings in the United States, and people are using it as a vehicle for spending.

Let's not forget the other research reports that have focused on people who are putting very little down on their home and pulling the equity out. Please don't forget when you look at this that there are many, many people in our country who have owned their homes since the 1950s and '60s, and sometimes live in the same home in the same neighborhoods, and the value of this property has exploded. It is allowing them, and baby boomers in particular, to liquidate that property and to take the money out and go somewhere else, to a place where there's a lower cost of living. So it's not to be underestimated.

I show you the change in private inventories only to reinforce the fact that when we are in the midst of a mid-cycle growth recession, we tend to have some contraction (see Chart 20). We had one quarter of contraction in 1986, we almost had one in 1995, and we may have already had one in the fourth quarter of last year, which, again, is another piece of evidence that leads me to believe that we may have just lived through our mid-cycle slowdown in this particular expansion.

Chart 20

Chart 20 Real Change in Private Inventories d

I want to show you a picture [in Chart 21] of the nonresidential investment spending in equipment and software, just to drive home the point that I expect that capital spending will be a driver of economic growth for the remainder of the decade. This, again, is due to Dale Jorgenson's thesis that we have capital deepening going on, and companies will continue to be upgrading software and hardware and figuring out ways to use the Internet to be more efficient.

Chart 21

Chart 21 Real Private Nonresidential Fixed Investment: Equipment and Software d

Of course, the big mystery is why the dollar hasn't broken down, given such a large current account deficit, and for that I'd have to turn to Catherine Mann's thesis from the Institute of International Economics on the co-dependency between the United States and China.

Last year, I had a really good call on the dollar. When most people were bearish, I predicted that the dollar would not break through the old 1995 low, primarily based on President Bush's aggressive agenda for structural reform of health care and Social Security, and also by looking at this chart and concluding that we wouldn't break through, on a trade-weighted basis, the old 1995 low on the dollar. [In Chart 22] is a picture of the trade-weighted dollar versus the 10-year note, just to drive home my thesis that the dollar will probably stay in a range of 82 to 84 this year. That's, again, the trade-weighted dollar. If my guess is right, we could have low, sustainable long-term interest rates for a long time. And by that I mean between 4 and 5 percent indefinitely for the remainder of the decade.

Chart 22

Chart 22 10-Year Treasury Note Yield at Constant Maturity d

Why? Because we're living in a disinflationary environment. Why? Because the Chinese continue to buy our long-term debt. Why? Because they're not going to disenfranchise themselves of U.S. securities for diversification of portfolio. The adjustment will be at the margin.

And I want to conclude with two pictures on gold. Tim Geithner, at the NYABE [New York Chapter of the National Association for Business Economics] last week, referred to puzzles in asset prices and how asset prices are increasingly figured into the making of monetary policy. And gold is always signaled when there's inflation. Back in 1987, it told us there was inflation in real estate and in stock prices (see Chart 23).

Chart 23

Chart 23 Cash Price: Gold, Handy and Harman Base Price d

So if Milton Friedman is correct that inflation is now and always a monetary phenomenon, and it's signaled through gold, you have to wonder, where is the inflation? So I put it against industry home prices. Clearly, we've had inflation in home prices. Again, I would paraphrase that home-price inflation as being not broad-based across the country but in specific markets.

And, again, this chart shows gold against the S&P 500, just to drive home the point that gold is signaling that there's inflation somewhere (see Chart 24).

Chart 24

Chart 24 Cash Price: Gold, Handy and Harman Base Priced

One of the things that Greenspan said at the Jackson Hole conference—and I want to leave you with this thought, because I think it's a good one—is that during the last two decades, 25 years or so, we've lived through what has been a period of rolling bubbles, with money moving in and out of asset classes, bubbles forming when the values in that asset class become overvalued, then moving out to a different asset class.

So it has been a period of extreme flexibility in the economy. And I think that Greenspan's remarks at Jackson Hole are apropos to what we're dealing with here today. If we can maintain an adequate degree of flexibility, some of America's economic imbalances, most notably the large current account deficit and housing boom, can be rectified by adjustments in prices, interest rates, and exchange rates, rather than through more wrenching changes in output, incomes, and employment.

And I think that's a particularly good thought to end with, because I think we can stop asset price inflation, the one that we're experiencing right now, without it actually impacting the real economy. Instead, let it fall on the broadest shoulders in the financial markets, where they can clearly absorb it.

I'll conclude there. Thank you.

MR. BROWN: Thank you, Kathy.

Last Updated 04/12/2006 communications@fdic.gov