Now that the Recession is Over, What's Next?

Now that the US recession has officially been declared as being over, the most obvious and pressing question is where we go from here?

As there are confusions about what a recession or recovery actually means (see the previous post), there are just as many confusions concerning whether we are actually in a recovery or a recession. I have provided a chart that will help to illustrate this point (click the chart to enlarge it).

I think it is safe to say that generally, most people refuse to believe the pronouncements of economists concerning when an economy is in the very early stages of either recession or recovery. Consider early recession in the chart. Note that the economy is not very far from its peak in economic activity. So, when economic data are released, the numbers are still very good in a historical context. In fact, unless you focus on what economists refer to as leading economic indicators, the numbers will show an economy that is still climbing the activity "hill" (i.e., to the left of the peak), making it even more difficult to assess what is actually taking place. Perhaps the best example of this is the one measure the general population focuses on most -- the unemployment rate. This is a lagging indicator, meaning its level at present reflects what happened in months past. Remember: a recession is NOT defined as a level of diminished economic activity. As the National Bureau of Economic Research (the "dating" body for economic cycles) points out, it is instead a period of diminishing activity. This highlights the distinction between levels and rates of change that I discussed in the previous post.

Right now, nationally at least, we find ourselves in the early stages of a recovery. Once again, look at the chart above. In the early stages of a recovery, an economy is close to the "bottom" of economic activity. The numbers that are released are therefore not going to be very good, and after a recession period, often discouraging. Of course, if you focus on lagging indicators, you will almost certainly conclude that we are still in a recession.

At this point, I need to reiterate that contrary to popular "wisdom," being in a recovery does not necessarily require a return to "normal" times and historical averages (or above) of economic variables. It might. But generally it takes some time to get back to "typical" levels. The next chart will help to explain this.

As this chart should illustrate, not all recoveries are alike. Each path reflects how rapidly economic activity will be rising in the future. Historically, when there is a very deep national recession like the one we just had, the economy rebounds quickly. This leads to a "V" shaped recovery (the green line). It doesn't take all that long to return to "normal" levels of economic activity. In that situation, a recovery feels like a recovery.

But recovery paths are different since not all recessions are the same. Global recessions occur over longer periods and are generally more damaging than more "typical" recessions. When there is a global recession with major financial problems, as the one we just had, the pace of recovery tends to be slow and it takes a longer time to return to "normal" levels of economic activity (the red line). Consider that at present, individuals are spending less, saving, and paying down debt. Banks have lowered leverage. All of this is very positive in the medium to longer term, but it extracts a cost on the rate of economic growth in the short term. Add to this  the fact that banks aren't lending as much as they might have in previous recoveries, and you get what Mohammed El-Erian of Pimco refers to as "The New Normal" (click here for a video of El-Erian explaining this concept). He and I are somewhat concerned with the possibility of deflation in the near-term as well.

So, where does all of this leave us? What are you to think? Hopefully you are now more aware of  the basics of what is really going on, what an early recovery means, and the possible paths the US economy might take. THE question is which path will be the one our economy follows. Let me be very honest about this: economists, including me, don't really know the answer to this, in spite of all our forecasts and predictions. In this context, let me state one of my favorite sayings: CERTAINTY IS AN ILLUSION. Any forecast, no matter who makes it, is essentially a scenario. It assumes what the areas are that will be the most important over the forecast period, how each of those areas will actually change, and the interactions between and among them. Obviously, there are numerous sources of potential error.

In a period of such uncertainty, where things seldom appear to be what they actually are, many persons are all too willing to step forward with their "solutions." While these might sound good, or appeal to the increasingly subjective notion of "common sense," they too are based on scenarios. So, they might be right. Or, they might be wrong. Let me recommend that you critique any or all of these within the context of one of my favorite sayings: "Complex problems have simple, easy to understand, wrong answers."

Let me finish by acknowledging that at this point you are no doubt wondering where I stand on the future path of economic growth. I will outline this in the coming days (it's time for me to get to class). Before doing that, I need to apply the information in these last two posts to what is occurring in Rhode Island. Stay tuned!

The US Recession is Officially Over

Today, the group officially responsible for applying dates to national business cycle turning points (i.e., recessions and recoveries), the National Bureau of Economic Research (NBER), declared that the most recent recession ended in June of 2009. Read their full statement.

Just as most people didn't realize we were in recession for quite some time after the most recent recession began, many didn't realize that we have now been in an economic recovery for over a year. There are several reasons for this.

First, a (national) recession is not defined the way most people think it is. Apparently almost everyone believes that a recession occurs when the US economy experiences at least two consecutive quarters where real (inflation-adjusted) GDP declines. This definition is predicated entirely on the behavior of a single variable -- national output, which would be declining for at least six consecutive months. Were this the definition, it would be very easy to "date" recessions: count to two after checking GDP releases, looking for negative growth rates. Second, the NBER does not do things this way, nor do they restrict their analysis exclusively to quarterly data. Read the Q&A about the way they define recessions and recoveries. In this, the NBER states a very important point: a recession isn't defined as being a period of low activity, but a time period of continually declining economic activity. Extending this to recoveries, these don't necessarily indicate a return to "normal" times. Instead, they reflect continually improving economic activity in a number of areas.

What is the actual definition the NBER uses to define a recession? According to the NBER, a recession is defined in the following way:

"The NBER does not define a recession in terms of two consecutive quarters of decline in real GDP. Rather, a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales."

So, from this, what we can infer is that as we are now about a year into a national economic recovery, economic activity in a number of areas is improving (on average). THIS DOES NOT MEAN WE HAVE RETURNED TO "TRADITIONAL" LEVELS OF THESE VARIABLES. That could take months or even years, especially as our economy is in a period where persons are saving and paying down debt, and bank lending is not as great as we would like to see it.

Confusion surrounding the dates of recessions and recoveries is the manifestation of a very basic observation I will make: persons instinctively focus on the levels of economic variables; economists extend this focus on levels to rates of change as well. So, the rate of economic growth is just that -- a rate of growth and thus a measure of rate of change. Actually, economists often go farther, as we are now concerned about whether the rate of economic growth will be slowing. This means economists are now focusing on rates of change (are we slowing?) in the rate of change (the rate of economic growth). You will often hear this referred to as the "second derivative" of economic activity. Clearly, economists think and speak a different language than do most people, often defying "intuition."

Gold Breaks $1,000

Friday was a roller coaster day for the stock market. The Dow-Jones, down by over 200 points in the early afternoon, finished "only" down 100 points, as the Obama administration assured a nervous market that nationalization of banks was not imminent (apparently, many thought this weekend could have ended with a surprise not unlike we saw at the end of last year -- this time nationalization of both Citigroup and Bank of America). You can read about this.

While the stock market was gyrating, gold rose to over $1,000/ounce (click here for story). While that is not far from the record in nominal terms, it was very far from the all-time record in real terms (around $2,200 in 2008 dollars). The move to gold was a flight to safety, not unlike what we often see for bonds (review Supply and Demand notes). Globally, markets are unsure about how long and severe this recession will be. So, rotate from stocks to bonds (interest rates fell Friday) and gold. Part of what underlies this uncertainty can be seen all too vividly with the following graph:

Gains that accumulated over five years have been wiped out over the last year and a half! We have now broken below support from 2002. Look closely at the most recent two price bars and the information they contain.

Where do we go from here? The only good news in the chart is that the RSI is giving an extremely oversold reading (of around 10). So, based on the way markets usually work, we are due for an oversold bounce. But other things are not equal. So, when might the bounce occur?

This is where you need to add economics to model the Dow-Jones average. Recall, the two primary factors moving it are interest rates and profit expectations. Interest rates for now are not a concern, so focus primarily on profit expectations. Predicting them necessarily requires a forecast of credit availability and financial system workings (read this intriguing article). Because this is so uncertain at present, opinions change every day. As market participants continue to change their minds often, they move in and out of different assets and stock sectors, causing volatile stock prices (referred to as the repricing of risk).

Expect this to continue until markets see a predictable (not necessarily effective) direction for financial markets, housing prices, and overall economic activity. ALL THREE ARE ENDOGENOUS AND SIMULTANEOUSLY DETERMINED.

Friday, October 3: Employment and Vote

This morning, the US Bureau of Labor Statistics released its September employment report. True to expectations, payroll employment fell by 159,000 relative to August. There were some revisions to earlier months, but these were very small (actually positive). The unemployment rate remained unchanged at 6.1% (I had expected this to rise), and average hourly earnings rose by 0.2%. Read this article about the report.

What reaction did markets have to such a disappointing report? The opposite of that expected. Stock market futures improved substantially. And, with this "bad news," interest rates rose, as did the US dollar. Perhaps the only expected result was the movement out of industrials, which are cyclically sensitive. What happened?

"Other things" were not even close to being equal. The weak employment report was perceived as increasing the likelihood of the passage of the rescue plan later today. Furthermore, credit crisis effects weren't even reflected in this report, so employment reports in future months should be even more disappointing. Thus, markets are also building in the presumption of Fed rate cuts, possibly today if the legislation fails to pass.

What about industrials? These are pro-cyclical, so with a slowing economy, you should expect these to decline. But, industrial companies also tend to rely substantially on externally generated funds. So, in light of the current and ongoing financial difficulties, even if the rescue legislation passes, there are questions about how far down industrials might fall in coming months. Where did the money exiting industrials go (rotate) to? Large banks, who have the money, even if they don't necessarily want to lend it. Graph XLI on Stockcharts.com and observe its behavior over the last few days and contrast that with today.

Let me reiterate that I continue to believe the Fed must lower interest rates. Remember, the Fed has a target of 2%, but the fed funds rate is a market rate that isn't always at its target. So, go back to the graph we did in class with real money demand falling due to a slowing economy and the Fed having a target of 2%. Were they to have kept the fed funds rate at 2%, the money supply would have been falling. But, all the injections of liquidity over the past few weeks have made the actual fed funds rate much lower than the 2% target. So, if the Fed decides to keep its existing 2% target and enforce it, they would have to undertake major withdrawals of liquidity, which would further exacerbate the current national recession (I continue to believe the US has been in a recession since January) and global weakness.

Finally, even if the rescue legislation plan passes (and I expect it will), DO NOT expect equity markets to go straight up from here. There is still a national recession, Europe and Asia are weakening, and global weakness will continue moving forward. And, last Monday when it was presumed the legislation would pass the first time around, the market was down about 3% even before the vote. There is an old saying in the stock market: Buy on the rumor, sell on the news. So, "the news" will be passage of the legislation. And, lots of money is waiting to sell any rally. So, don't be surprised if the market is down, maybe by several hundred points, for the day. And, if the legislation is passed, the anti-shorting ban will have a time table for expiration of a few days. What will happen when this is removed?

As I write this post (10am on Friday), the Dow Jones is up 136, NASDAQ is up 44, and the S&P 500 is 23 points higher. The 10-year bond is up 3 bp to 3.67%.