Wednesday, April 18, 2007

US Recession?

I believe that the US economy is soon to enter a recession, for the reasons I outline below. As with all macroeconomics, not all economists agree with my conclusion here, so you're welcome to disagree! Ultimately only time will tell, and even if I am right (or wrong for that matter), it may be for the wrong reason! The economy is always subject to shocks; regardless of the path of the economy right now, a large enough positive or negative shock would be enough to override the path I believe the US economy is on now. Here, in brief, is my "forecast" of the US business cycle.....

1) The US economy has enjoyed rapid growth in recent years. The main driver of this growth has been increased consumption, which makes up about 70% of GDP. But the increase in consumption has been much faster than the increase in income. This has been possible because household assets- in particular houses- have been appreciating rapidly. Many households have taken advantage of the appreciation by re-financing their home (that is, increasing the size of their mortgage), using some of the increased loan to increase consumption. Overall, this effect is large: average household savings in the US is now NEGATIVE.

2) BUT the increased value of homes in the US has not been sustainable. There is some evidence that a portion of the increase in house prices was due to speculative behaviour, and as speculation has dried up, house prices have started falling in many parts of the US. (Just search "subprime mortgage" on to find evidence of where some of this speculation has come from: mortgage lenders offering generous terms to people with poor credit and low incomes has increased the demand for homes substantially, pushing up prices).

3) If the increase in house prices has driven increased consumption in the past, and consumption is now above sustainable levels (as evidenced by negative household savings), then it is highly likely that the same process will occur in reverse as house prices fall.

4) In recent months, the growth rate of the US economy has already fallen (from 3.5% to about 2%), largely due to decreased investment. But to date, consumption has remained stable. When consumption starts to fall (as I believe it must), this will cause a further reduction in growth, most likely driving a fall in the level of GDP- i.e. a recession.

5) Once US growth falls substantially, inflation will also fall. That will allow the Federal Reserve to ease monetary policy, by lowering interest rates. However, I expect that their change in policy will be too little, and too late to stop a recession.

It is very difficult to predict the timing of changes in the business cycle. Most likely, I expect the US will be in recession before the end of the year, and the Fed will cut interest rates by at least 1.5% by May 2008.

As I mentioned above, this is a forecast; I could be wrong for many reasons. Your comments are welcome.

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