Gentle reader,

Here is an excerpted take on the question of a double-dip recession, from the people at CalculatedRisk, a blog I dip into now and again. Echoes a post here a couple days ago, but with some more detail. Call us a pair of Pollyannas, but maybe we’re onto something.

Personally, I get nervous when conventional wisdom all moves in one direction — as the sliding markets lately seem to suggest. I’ll stick with the contrarians.

Tuesday, June 29, 2010
2nd Half: Slowdown or Double-Dip?

by CalculatedRisk on 6/29/2010 04:00:00 PM

No one has a crystal ball, but it appears the U.S. economy will slow in the 2nd half of 2010.

For the unemployed and marginally employed, and for many other Americans suffering with too much debt or stagnant real incomes, there is little difference between slower growth and a double-dip recession. What matters to them is jobs and income growth.

In both cases (slowdown or double-dip), the unemployment rate will probably increase and wages will be under pressure. It is just a matter of degrees.

The arguments for a slowdown and double-dip recession are basically the same: less stimulus spending, state and local government cutbacks, more household saving impacting consumption, another downturn in housing, and a slowdown and financial issues in Europe and a slowdown in China. It is only a question of magnitude of the impact.

My general view has been that the recovery would be sluggish and choppy and I think this slowdown is part of the expected “choppiness”. I still think the U.S. will avoid a technical “double-dip” recession.

Usually the deeper the recession, the more robust the recovery. That didn’t happen this time (no “V-shaped” recovery), and it is probably worth reviewing why this period is different than an ordinary recession-recovery cycle.

# First, this recession was preceded by the bursting of the credit bubble (especially housing) leading to a financial crisis. And there is research showing recoveries following financial crisis are typically more sluggish than following other recessions. See Carmen Reinhart and Kenneth Rogoff: “The Aftermath of Financial Crises”

An examination of the aftermath of severe financial crises shows deep and lasting effects on asset prices, output and employment. … Even recessions sparked by financial crises do eventually end, albeit almost invariably accompanied by massive increases in government debt.

# Second, most recessions have followed interest rate increases from the Fed to fight inflation, and after the recession starts, the Fed lowers interest rates. There is research suggesting the Fed would have to push the Fed funds rate negative to achieve the same monetary stimulus as following previous recessions. See San Francisco Fed Letter by Glenn Rudebusch The Fed’s Exit Strategy for Monetary Policy.

The graph from Rudebusch’s shows a modified Taylor rule. According to Rudebusch’s estimate, the Fed Funds rate should be around minus 5% right now if we ignore unconventional policy (obviously there is a lower bound) and probably close to minus 3% if we include unconventional policy. Obviously the Fed can’t lower rates using conventional policy, although it is possible for more unconventional policy.

# Third, usually the engines of recovery are investment in housing (not existing home sales) and consumer spending. Both are still under severe pressure with the large overhang of housing inventory, and the need for households to repair their balance sheet (the saving rate will probably rise – slowing consumption growth).

On this third point, I put together a table of housing supply metrics last weekend to help track the housing market. It is hard to have a robust economic recovery without a recovery in residential investment – and there will be no strong recovery in residential investment until the excess housing supply is reduced substantially.

During previous recoveries, housing played a critical role in job creation and consumer spending. But not this time. Residential investment is mostly moving sideways.

It isn’t the size of the sector (currently only about 2.5% of GDP), but the contribution during the recovery that matters – and housing is usually the largest contributor to economic growth and employment early in a recovery.

Two somewhat positive points: 1) builders will deliver a record low number of housing units in 2010, and that will help reduce the excess supply (see: Housing Stock and Flow), and 2) usually a recession (or double-dip) is preceded by a sharp decline in Residential Investment (housing is the best leading indicator for the business cycle), and it hard for RI to fall much further!

So I’m sticking with a slowdown in growth.

Wall Street’s Jitters — Just a Summer Chill

Wall Street’s jitters about the durability of the economic recovery are beginning to get worrisome – at least to investors. The question is, however, are all those flashing yellow lights really portending another economic plunge, a so-called “double-dip?”

My answer: nope. It seems more likely that the market’s enthusiasm for the recovery just got ahead of itself. Call it another dose of irrational exuberance or, more likely, just excessive exuberance. I suggest that the latest reversals are nothing more than a predictable correction, not an ugly omen. Indeed, I’m reminded of economist’s Paul Samuelson’s hoary trope, hailing from a Newsweek column in 1966, that “Wall Street indexes predicted nine out of the last five recessions.”

Let’s look at the numbers. The S&P 500 index, which closed at 1,095.31 on June 22, has slipped 11.1% from its April 23 peak. On its face, of course, that drop seems big enough to rattle cages from Manhattan to Manchuria. Northern Trust economist Asha Bangalore, who has argued that the S&P 500 index is a “leading indicator par excellence,” pointed to a smaller decline in the index – less than 7% — in early 2008 to suggest that a “rough ride” was in store that year.

Of course, she was right. But, as with any economic question, it would all seem to boil down to timing and perspective. If we pull back the camera to take in a broader picture, the S&P 500 has been on a tear for nearly a year. Between the middle of last August and its late April high, the index climbed 24%. True, the 1,217.28 point peak in April was a long way from the nosebleed pre-recession October 2007 1,565.15 point. Still, that 24% rise over just nine months would seem to make a correction all but inevitable. Indeed, Bangalore herself has noted that the S&P 500 has given off “false signals.”

Pointing to the dazzling climb of recent months, some analysts have marshaled data to show, in fact, that the stock market has been wildly overvalued. The folks at Smithers & Co. contend the overvaluation tops 50%.

Out in the real economy, the rebound from recession certainly has come nowhere near the market’s lofty expectations. After plunging 6.4% in early 2009, the U.S.’s gross domestic product eked out a 0.7% annualized gain last spring, a 2.2% summertime rise and then leapt 5.6% in the winter quarter. Since then, GDP growth has slowed, notching a 3% rise in the first quarter of this year. Does this justify a 24% gain? A cooling, reflected in the market’s latest slide, seemed baked in the cake.

The big question, of course, is whether the cooling is likely to turn frigid this summer. Possible, but it seems unlikely. For one thing, policymakers seem committed to keeping the growth on course, with the folks at the Fed signaling zero interest in raising interest rates. For another, the pressure continues to grow on bankers from President Obama on down to ramp up their still-anemic lending – and the economy managed in the last year to grow even without all the help that looser lending might bring. Sure, Washington’s tap may be dry, but the bankers’ isn’t.

Just as the economy’s slide was anything but orderly, the recovery seems likely to be a stop-and-start sort of thing. One step back for every two forward, as the cliché goes. Lately, we’ve had a step back, for sure. Indeed, the outfit that fixes dates on recession and recovery – the National Bureau of Economic Research – still isn’t confident enough to say that recovery has been under way, despite the year’s worth of positive GDP performances.

But investors who look at the latest gloom on the Street and see darker clouds ahead could be missing the bigger picture. Summertime storms, maybe. And it may yet be a long time before recovery is so strong that it makes a dent in the painfully high unemployment rate. But, if history is any guide at all, the blasts will pass.

(This ran first on the Tabb Forum site).