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Rarely have we seen such a glaring disparity between how the Federal Reserve sees the outlook for the American economy and how the financial markets perceive things.
The facts are the same for everyone: In 2006, the US economy slowed noticeably, while the rate of consumer inflation briefly increased before settling back recently. Economic growth came down from 3 ½ percent to around 3percent. Mostly the slowdown reflected a spectacular weakening in housing activity. Sales of new and existing homes have dropped about 20 percent. Housing starts and building permits are down 35 percent, one of the sharpest declines in history. Average home prices are falling nationwide for the first time in decades. A third of all contracts to buy new homes are being cancelled. Prospective homebuyers are willing to pay a penalty to avoid having to buy a house they can no longer afford and which may lose value.
Meanwhile, US automobile industry has faced mounting problems. Many leading manufacturers of auto parts are bankrupt, and both GM and Ford are undertaking wrenching cutbacks of staff and facilities to avoid that fate. Half of Ford’s hourly workforce accepted buy-outs, and the company will close dozens of factories to reduce capacity.
Yet, important sectors of the US economy remain strong. That has kept the job market pretty sound. Employment is rising, and the unemployment rate has drifted down to a modest 4 ½ percent. Makers of sophisticated capital goods are doing particularly well, boosted by strong demand from both domestic and foreign companies expanding their capital expenditures. Many services industries also enjoy strong revenue growth and higher profits. They, too, are investing in technology and software. But the US trade deficit remains huge, amounting to an enormous 7 percent of GDP. That means the US as a country spends much more than it earns.
As for inflation, the headline figure was jerked up and down by massive swings in energy prices. The rate of increase in core consumer prices (excluding food and energy) peaked above 3percent per annum during the springtime but has subsequently eased back to around 2 ½percent or so.
This mixed picture—broad strengths punctuated by serious weaknesses—is undeniable. Where the Fed and the financial markets differ is on what happens next. The US central bank is convinced that the US economy will experience moderate growth in 2007 and that the dangers of a rise in inflation are greater than the risks of unacceptably slow growth. So it continued to raise short-term until pausing at 5.25 percent last summer. It keeps threatening a further firming of monetary policy if the inflation backs up again. It only just began to acknowledge any downside risks to growth in its latest policy statement on December 12.
The financial markets have a strikingly different view of the future. That is readily observable from the shape of the yield curve. Short-term interest rates are higher than long-term interest rates. That means that on balance market participants expect that the Fed will soon be lowering interest rates to guard against a recession. They are concerned that the profound weakening in housing activity will spill over onto the rest of the economy. They worry that falling home prices will squeeze consumers. They see the possibility of additional business failures, whether in the auto sector or elsewhere.
But why then has the US stock market been so strong? The answer is simply that, like the bond market, stock markets also expect the Fed to ease monetary policy. Equity investors recognize the dangers to sales volumes and profitability. But they are buying stocks in anticipation of lower interest rates.
Naturally, the rallies in the US bond and stock markets will cushion the negative effects on the US economy from falling home prices. In the end the Fed won’t have to cut rates very much to prevent a soft landing turning into a hard landing.
But the downside risks are not negligible. Our models, based on business cycle history, suggest that there is about an 80percent chance of growth in 2007 that is at least one percentage point lower than the long-run average of 3.25percent. But there is also a 35percent chance of a recession. We also estimate a 90percent probability that core consumer inflation will be lower in 2007 than this year.
In short, in the debate between the Fed and the financial markets, we side with the markets. A year ago, the Fed’s growth forecast for 2006 was too optimistic and it is likely to repeat that mistake. But in an environment of mild and slightly declining core inflation, the Fed has plenty of flexibility to cut interest rates as insurance against nastier business conditions than it now anticipates.
