2006 Economic Outlook Roundtable:
Scenarios for the Next U.S. Recession
Presentation of Kathleen Camilli, Chief Economist and Director, Camilli Economics
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
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."
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
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
So from my perspective, we're nowhere near an outright downturn in the
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.
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
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.
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.
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.
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).
[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.
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,
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
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.
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.
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.
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.
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.
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.
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).
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
And, again, this chart shows gold against the S&P
500, just to drive home the point that gold is signaling that there's
(see Chart 24).
One of the things that Greenspan said at the Jackson
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.