Warning flags flutter on economy

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Economists are reluctant to forecast recessions, especially since they have become less frequent in recent years. It is professionally damaging to wrongly predict such a slump.

Economists are less reluctant to warn of trouble ahead, such as a housing bubble bursting, trillions of dollars in loan-related financial packages coming unglued, or the dollar plunging as huge United States trade deficits continue.

In general, economists do modestly better at predicting the economy than simple mathematical projections of past economic trends do. But economists often get into trouble when they try to foretell financial downturns.

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Perhaps that's why most economists are cheery about the health of the US economy.

Economists and policymakers at the US Federal Reserve also have a history of upbeat forecasting. They didn't see the last recession in 2000 and 2001 until about nine months after it started.

That's typical, because the Fed and other economists rely on financial data collected with a lag of a month or more.

"It is like driving down the road with your eyes glued to the rearview mirror," says Harald Malmgren, a Washington consulting economist. "When a bend in the road comes, this navigational technique is unreliable."

Many stock-market investors are aware of this risk. Late last month, the Fed raised short-term interest rates one-quarter of 1 percent for the 15th time since June 2004, to 4.75 percent. With long-term interest rates also rising, many investors wonder if the Fed will overdo monetary tightness again, causing an economic downturn.

So when minutes of the last meeting of Fed policymakers hinted they might end their anti-inflation drive and not boost interest rates next month, stock prices rose dramatically last week.

"If the Fed doesn't stop raising rates soon, the recession flag could go up," warns Paul Kasriel, an economist at the Northern Trust Co., a Chicago bank.

Yet he, like many other economists, sees problems for the economy. "We have a very accident-prone global economy right now," Mr. Kasriel says.

Among the perils he and others see:

Risky mortgages, riskier derivatives

The Fed is concerned over the rapid expansion of nontraditional mortgages, such as interest-only loans and those where the size of the loan grows, rather than shrinks. The Fed and other US financial regulators have produced a draft "supervisory guidance" for participants in the US mortgage market. A final version of this guidance, when it emerges, could constrain the home-mortgage market later this year, Mr. Malmgren warns. Similarly, regulators are trying to tame the market for risky loans linked to commercial real estate.

In the international sphere, the Fed and banking regulators in Britain and other nations worry about the rapid expansion in recent years of high-risk "credit derivatives," now in the trillions of dollars. Such derivatives are often built around repackaging existing debt.

"Most of this market is concentrated in a little more than one dozen financial institutions, posing potential systemic risks on a scale never before experienced," Malmgren says in a monthly commentary. These financial instruments spread the risk of these loans among various creditors (hedge funds, insurance companies, pension funds, etc.). That's useful. But it doesn't eliminate the risk from rising interest rates or recession, he says.

"The Fed and other regulators have grown nervous about the proliferation of financial innovations as well as the types of market participants," Malmgren writes. As the world economy slows, "exits from these illiquid assets may get crowded from time to time."

Kasriel also sees serious derivative risks in the "highly leveraged global economy" as central banks in Europe and Japan join the Fed in raising interest rates from an "abnormally low" level.

The shrinking real estate bubble

"We are seeing the end of the bubble," says Dean Baker, codirector of the Center for Economic and Policy Research in Washington. "How quickly and how much [prices fall] remains to be seen.

Signs of a weakening housing market include a fall in housing starts last month, a five-month-long slump in existing home sales, and a 15 percent drop in mortgage applications from a year ago.

The average interest rate on a 30-year fixed-rate mortgage has risen from 5.3 percent in June 2003 to 6.5 percent - enough to boost mortgage payments sizably. More and more people with adjustable rate mortgages will not be able to afford the new payments and will have to sell, says Baker.

Residential construction accounts for 6 percent of gross domestic product. Real estate agencies employ 1.5 million people. If house prices decline, homeowners will be less likely to draw money out of their home equity to buy goods and services. Further, if housing starts of 2.1 million in 2005 fall to the 1.2 million to 1.3 million level common in the 1980s and '90s, this "could throw the economy into a recession," says Baker.

That pesky US trade deficit

The economy is switching from an expansion led by husky consumer spending to one led by business investment, says economist Nicocles Michas of Alexandros Partners LLC in Waltham, Mass. He sees the rate of real growth falling to a low 2 percent later this year. Then foreigners could become "more cautious" with investing in dollar-denominated bonds, etc. The dollar could tumble, interest rates rise, and stock-market prices could weaken.

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