This week's guest is Anirvan Banerji, director of research for the Manhattan-based Economic Cycle Research Institute, the foremost institute of research into leading indicators of the economy. At the Center for International Business Cycle Research at Columbia University, he was in charge of the Business Week Leading Index, as well as the Journal of Commerce Industrial Materials Price Index.
Banerji serves on the Economic Advisory Panel of the New York City Office of Management and Budget, and is a member of the Organization for Economic Cooperation and Development (OECD) Expert Group on Leading Indicators. He also writes for RealMoney.com, our premium site.
Banerji will answer questions from moderator, TSC Senior Writer Aaron Task, and readers.
AT: In looking at the ECRI index of leading indicators for North America, it rose for the week ending December 21, resuming an up-trend in place since late October. What is the index telling us about the current state of the U.S. economy?
AB: It's telling us tentatively that a recovery could be imminent, but we have to be appropriately cautious and use the same discipline in interpreting these moves now as we were when we called a recession. We have to look at the 3 P's. We must determine whether the advance is pronounced, persuasive and persistent. Since October, it has reversed almost half of its recessionary decline. We have to say that the upward move is reasonably pronounced. The question is whether it's pervasive enough to qualify. I need to contrast its move now with what happened in the spring when there was a rally in stock prices. The leading indicator did go up, but the leading indicators within the WLI (Weekly Leading Index), which is based more on the real economy, did not chime in. So we didn't take that rise in the WLI seriously back in the spring. It's different - this time there is a broad based rise in the index.
AT: I want to press that point. We've taken questions from readers and one has pointed out that from his assessment that it's mainly the financial aspect of the indicators that are on the rise and not the so-called real economic indicators. Can you discuss which of those are rising?
AB: We know that there has been something of a downtrend in initial jobless claims. Also mortgage applications for purchases as of the last reading were at a record high for that indicator. We have an industrial prices growth rate, but it did bottom out in early November. After that, it has become less negative. Those are just examples of the kind of things we are looking at which suggest that things are not just driven by the financial related market indicators. Those things are also important.
AT: What indicators gauge manufacturing for the manufacturing economy? You look at the ISM, formerly NAPM report, that showed stronger than expected moves for December. Is that an indicator that you use?
AB: One of the things that we do is include some of them in our other indexes. It's not weekly, but it's monthly. Some of those series are leading, and some are not. It's important to distinguish which is which and which parts of that report are useful for looking ahead. In the Weekly Leading Index, the most important indicator related directly to manufacturing is the industrial price growth rate. There we had a very negative growth rate in late October, early November. That has begun to turn around some. I'm not suggesting a strong reversal of downtrend, but there is something of a reversal. Perhaps it is true that manufacturing is not going to participate in the recovery as fully as some might wish.
AT: The third P - persistence - where do we stand in that regard?
AB: That's where we should be a little cautious. From the low point in October, we've had nine weeks during which advances have taken place. That's essentially two months. If you look at any indicator and you look at two months of upticks, how much does that suggest in terms of a reversal of trend? Two months isn't quite enough to make a persistent movement. That is why, going by the same discipline we used in calling the recession, we think it's a little premature to definitively call the recovery. Even though it is a reasonably pronounced move, it's not persistent enough yet. We'd like to wait a few more weeks before making a call. The reason we hesitate is that we are in a global recession, where for the first time in this generation, many economies are under a lot of pressure and stress points are getting stressed. If a weak link snaps and if that is a major shock that cannot be contained, that has the potential to knock the economy in the U.S. into a longer recession. Right now, it's in the window of vulnerability. Hopefully we'll be out of the window of vulnerability before we get any major shocks. But we do need to wait a few more weeks. We are looking at other indexes.
AT: Is there a defined point in time or level of the WLI where you can say, "OK, now, I'm confident enough to say we are in a recovery?"
AB: No, it's not that way. We are looking at a combination of pronounced, pervasive and persistent movements. If it's a pronounced enough movement and/or pervasive enough, then it can make up to some extent for lack of persistent movements, and vice versa. It's really got to be a cyclically significant move. In that indicator, all three factors count. If you have two of the three for all of one month, it doesn't quite qualify. We are looking for the combination. You look at how the index behaved during earlier recoveries. You compare it to earlier recoveries. When you are looking for a business cycle recovery, it's the level of the index, not so much the growth rate. Having said that, I have to say, the growth rate of this index is now at 0. It's the first time it's been out of negative territory since September 2000, which is when we first warned of the recession danger. In fact, it was in an article in
called "The Oil Recession."
AT: Those of us who read your work here at
had a bit of a head start on the recession, and we really appreciate it. Are the three indices measuring up the way you'd expect them to in order to come out of a recession?
AB: They are, but it's a bit premature to make the final call. In this recession, and what we hope will be this recovery, we are seeing the leading, coincident and lagging indexes move down and then up in the classic sequence. It's very durable. First the leading index goes up, then the lagging indicator starts to go up. It's not time for the lagging indexes to go up yet, and they haven't. Some people say we are in a recovery already. We only have the leading indicators through November, and soon we'll have December, but through November the coincident index was still going down, which means through November the economy was still in recession. Now that can follow the leading index up, but it hasn't started yet.
AT: This recession was unique in the post WW II experience because it was business led and not consumer led. What does that suggest about the state of the recovery? Does it change your expectations for how we're going to emerge from it, when we're going to emerge from it and how strongly we'll emerge from it?
AB: That's a good point. Essentially, we have a situation where businesses lead the way into a recession and consumers followed, kicking and screaming. What this means is, we have a situation where businesses are stuck with a great deal of overcapacity. It was business over-investing, that's one of the hallmarks of this particular recession. When you have that much overcapacity, there is really no incentive to invest more, even if you have very, very low interest rates. That was one problem. Second, the issue of profits was very central in driving this recession. Profits are always the key in every recession, but more so this time than in many decades. That's because we have this synchronous global recession, which means it even affects multinational corporations and exporters, which are normally cushioned in terms of profits because in the past when one part of the world would be going into recession, others would be doing well. Not this time, this time there's no place to hide. That's why there's the biggest profits decline in nominal terms in seven decades or so. That means that companies really don't have the money that is internally generated to invest. That is why even if they want to hire, they are going to be very careful before they start hiring a lot of people because they cannot really afford to start doing that until profits start going up. With profits continuing under pressure, especially with the rest of the world not being likely to recover very quickly, we have a situation where there are major drags even though we may get some sort of recovery. Business is very important because of both the direct role in spurring economic activity in investment and also because if they keep cutting people's jobs in the near-term, you have another drag on consumer confidence, which has been recovering, but not completely. We still have a tug of war going on. We are likely to get a fairly imminent recovery even though we are not being very definite yet. The question is, what kind of recovery?
AT: What danger is there, given the level of debt both at the corporate and consumer level? You're saying that the level of recovery will be less robust than most on Wall Street are hoping for? Businesses may not have the ability to borrow more money to make investments, to hire more people. There is the downward spiral.
AB: We are still vulnerable, and we don't need another shock. Hopefully there will be none that we can't contain somehow. Because we are in this window of vulnerability, and I'm still being cautious right now.
AT: You talked about the economy being in a "window of vulnerability" to major shocks. What about the shocks we've already had, from Enron's bankruptcy and Argentina's implosion? Can they remain contained?
AB: Hopefully yes. As long as they are contained, they're okay. It's normal to expect these kinds of crises to erupt, particularly in this time of global recession. It's not obvious that such crises can be contained. If it's contained, it doesn't hurt as much. I'm not able to predict which part of the world will have the next crisis, if any. If so, can we contain it? The risk remains, even though so far, we've dodged the bullet.
AT: Does that suggest that investors have gotten a little bit ahead of themselves in investing in the fourth quarter?
AB: To the extent that investors are making a correct assumption that there won't be any such shocks, perhaps the advance in stock prices is justified. The question is, what sort of recovery in earnings is being factored in? It's not clear that corporate profitability will bounce back strongly in the next few months. Clearly, it looks like the rebound is the kind that anticipates business cycles historically, but where do we go from here? We have to wait and see how strong the indicators get from here. At this point, we're still in the window of vulnerability. We don't expect to be vulnerable forever. If there is a shock coming, the later it occurs the better. Once the recovery is in full swing, we're less likely to be derailed by a shock. In fact, once the expansion is in full swing and the leading indices are strong, even a major shock doesn't derail an expansion. A good case in point is Pearl Harbor. Our long leading index goes back to 1919. It was going up quite strongly in December of 1941. Sure enough, Pearl Harbor didn't put an end to the expansion. The expansion just kept going. In fact, it was bolstered it even further with wartime spending, but that's a separate issue.
AT: How much of a factor is the billion dollars approved for the military? There has been increased spending on security issues in this country after the events of September 11. How much of a factor do you think it will play in the leading index and how much of a factor do you think it will play in the recovery?
AB: It hasn't been a decisive factor in the recovery. It has affected it indirectly. You have the markets becoming more optimistic sooner because of the way the war in Afghanistan has gone. It has not had a major impact on the index, but it has had some impact. These are the more endogenous variables. The ones that anticipate cyclical movement, the ones that turn without benefit of external shock - they are the ones that are driving the upturn in the index. That's why I'm reasonably optimistic. However, in the long term, if there is more spending it has the ability to booster economic prospects, but we haven't seen that yet in the index.
AT: Before we look forward, let's look back a bit. In March, the ECRI said a recession in the U.S. was "unavoidable." What were you seeing then? Can you talk about what caused the recession in the first place?
AB: There are two ways of looking at it, and both are important to understand. One, we have a very disciplined structure in terms of predicting cyclical movements. ECRI founder Geoffrey Moore was a pioneer in predicting business cycles. He put together the initial index of leading economic indicators. In terms of what we've done here in the 40 years since that work was done, there's been a great deal of progress in terms of both composition and construction methods. What we have in the Weekly Leading Index is a state of the art leading index that was able to see the recession when other indexes weren't able to see it. It's important to look to the Weekly Leading Index because we know there is no holy grail in terms of indicators. Even a single leading index is not enough to get a good view of what is really going on in the economy. We look at an array of different indices that will show us different aspects of the economy. We have indices for different sectors. We look at all these aspects separately, and that tells us what is really happening. By the way, the leading employment index plunged in February 2001 to a 19 year low. That was a final nail in the coffin in terms of changing our minds and telling us that if job losses were going to start in a recessionary manner, and that's what it said, then the consumer could not hold up. Even in the week before September 11, it showed you what happened prior to those events. This is far ahead of the way in which most people look at it. Most forecasters don't even use the leading indexes. They just extrapolate past patterns, and that's guaranteed to fail. What is the story that it's been telling us over the past few years? What's important to understand in this economy is the impact other economies have on our economy. That impact has been underestimated by most economists in this country. The 1990s were a period of asynchronous business cycle expansions, it means that countries took turns going into a recession. The 90s started with an English speaking recession. The United Kingdom, the U.S., Canada, Australia and New Zealand went into recession, as soon as they started recovery, you had Japan and Continental Europe going into recession. It was only in 1994 that you had all the major economies in a simultaneous expansion. What happened in 1994? Import prices started spiking up, industrial materials prices started spiking up and you had the Federal Reserve jump in to the surprise of the bond market, jacking up interest rates. That was a preemptive measure that successfully created a soft landing. After that, by early 1997, you had Japan going into recession and the Asian crisis. Then in the late '90s because you had Japan and other economies in recession, the U.S. enjoyed four straight years of decline in U.S. import prices.
AT: You think that was the key to the economy's growth beyond the productivity issue of the last few years?
AB: Yes. Whatever productivity growth we had here, the point is, what changed in 1999? What did the Fed do, in view of this new paradigm and higher productivity miracle? Why did they decide to raise interest rates? Japan started expanding. The Japanese expansion triggered the U. S. recession. You had a situation for the first time in 1999, when Japan started expanding, you had the first synchronous global expansion since 1994. That caught everyone by surprise. No one predicted Japanese expansion. Most thought they were doomed to a recession. The Japanese economy had a short anemic expansion from 1999 to 2000, where it grew at a 2% annual rate, but it was an expansion. But when the world's second largest economy starts expanding, even for a year, it messes up the demand supply expectations balance, and that's what happened. When Japan started expanding, you found that U.S. import prices after falling for four straight years started rising. The same happened with industrial materials prices. Suddenly you had imported inflationary pressures reinforcing domestic inflationary pressures. That's why the Fed had to start tightening in 1999.
AT: Right now the Fed fund futures and the Euro dollar contracts are expecting the Fed to start tightening fairly soon into 2002 in expectation of an economic recovery. Is it also telling us that it's expecting the global markets to start recovering?
AB: That, or they are once again making a mistake. Part of what went on in the late 90s is what I call attribution bias. All it is is when good things happen to us, we tend to take the credit and say we did it. When bad things happen, we tend to look for external factors to blame. It's someone else's fault. A lot of investors thought they were geniuses in the late 90s, and they attributed their successes to themselves. It was the same in the case of these economists who saw the U.S. economy have robust growth without inflation, something that was contrary to standard economic dogma. They looked around and saw that productivity growth had gone up said, "Aha, we did it." The important thing there is the idea that because we did it, it's something we can continue to do. They put a lot of faith in the Federal Reserve to avert a crisis. The good times can go on forever. It was this faith in the sustainability of this expansion that was our undoing. Essentially, the dumb luck factor, benefiting from the recessions of other economies, that was attribution bias on a national scale. Fast forward to 2002, and there's that danger again. I don't think people realize what happened in the late 90s. They're still debating the significance of the productivity rise, as if that was the cause. It isn't. We've been pointing this out for years. A recent Federal Reserve paper actually makes the point after examining the data that it was indeed import prices and not productivity that was responsible for the recent "Goldilocks Economy."
AT: Doesn't Greenspan and the Fed in general bear responsibility as well? They were also talking a lot about this enhanced productivity. In a lot of people's minds it cemented this idea that the New Era rationale was for real.
AB: A lot of economists on Wall Street and in academia were saying that we had this new era. If you want to point fingers, there are plenty of places to point.
AT: I don't want to point fingers, but a lot of people still have a lot of anger toward the Fed for spoiling the party.
AB: That's the point, when things don't turn out the way you want them to, it's someone else's fault. What I'm saying for this year, the important implication is that we need to see the same factors. What are they doing? If we see recovery, and we might, what does it do to inflation? When Japan is probably heading to its worst ever recession and you have a world economy which is not at all firing on all cylinders, there is a lot of over-capacity around the world, and companies don't have much pricing power, which pressures their profits. Import prices for the U.S. will continue to be pressured. Import prices are falling. You have the likelihood that they will continue to offset any inflationary pressures that a recovery might generate. That is the part, the global economy, that most analysts on Wall Street fail to take into account.
AT: You don't expect the Fed to do much tightening this year?
AB: I can't predict what the Fed is going to do. Inflation pressures are at a 26-year low, a generational low. That tells you something going forward. As long as you have the conditions that were analogous to what we saw in the late 1990s - imported disinflationary pressures and deflationary pressures that counter domestic inflation pressures, if any. You don't have a situation where inflation becomes a real issue. That's something to take away from the past as a lesson for the future.
AT: What about the other side of that coin? What about deflation and the possibility of Japan pulling the rest of the world into a global deflationary cycle? Do you see that as a major risk?
AB: No I don't. There is some risk from the possibility of a major shock coming out of Japan like a banking crisis. If it comes early enough it can hurt the U.S. economy. The U.S. has the Federal Reserve and policy makers who have learned from lessons of the past and from the Great Depression. More important from a historical perspective, for a deflationary environment to set in, you had to have a situation for a period of many years where periods of recession are longer than periods of growth. Unless there is going to be a reversal of that, then there is no need to expect a long period of recession. Anyone who has looked at what the price of services has been doing, looking at healthcare and insurance, won't worry about deflation. Will inflation remain subdued? That's very likely.
AT: What are the deflationary implications of China's entry in the WTO? Is that going to put pressure on importers and exporters?
AB: China's entry is important, but the impact of low cost manufacturing was already making an impact on the world economy. We saw Taiwanese production move in a big way to mainland China. This was a hollowing out of the Taiwanese economy. A lot of Taiwanese were concerned. Korea, Japan - these countries were concerned about the same kind of phenomena. We are in a global recession where buyers are keen to get goods at lower prices. The low cost producer is likely to gain market share. The same thing is happening with India. They are a low cost producer of software and are able to make market-share gains. In effect, in this global recession, the low-cost producers are able to make inroads into other countries products and services. That is a significant shift and creates pressures in prices. Can it cause deflation? Yes. The U.S. isn't quite as vulnerable, but other countries are.
AT: What are the ECRI's Global Indicators telling you about the state of the global recovery and the possibility for recovery there?
AB: In North America, the prospects of a recovery are good. In Europe, Germany, which is in recession, is not yet looking to a recovery. The Euro-zone is not looking to stronger growth very soon. Their outlook is gloomy for the short term. Japan looks terrible. They look like they are heading for their worst recession ever, and that concerns me. They are important because they have an important economy. It's important for the world and for their neighbors. The global economy may not be ready to turn around, but the U.S. economy may be ready to lead the way for the world. But it's premature to predict the global recovery.
AT: Can the U.S. return to being the island of prosperity? Or will we be the least worse off?
AB: The U.S. has a remarkably resilient economy. The events of September 11 were horrific, but it didn't knock the U.S. into a recession. There are other countries that are doing okay. The United Kingdom never went into recession and neither did Australia. We are still at a point in terms of a recovery where we are not out of the woods. There is reasonable hope that the rest of the world will follow suit. Japan still troubles us.
AT: To wrap it up, some people argue that the events of September 11 accelerated things and shortened the recession.
AB: I wouldn't say that. To the extent that industries like the airlines went into depression, that's not entirely true. September 11 hurt. It did make the recession longer. It might have ended earlier without September 11. It's important not to give the terrorists credit for things that they didn't do. They were not able to bring the U.S. economy to its knees.
AT: Well maybe I'm looking for some sort of silver lining to those events.
AB: It's important to take heart in how resilient this economy is. If we do enjoy this kind of non-inflationary growth this year, which is likely, we shouldn't make the same mistake and say, "We did it again ? this recession was kind of a bump in the road." We have to learn from the mistakes we've made. The main mistake was attribution bias. We have to understand what it is that drove the recession and the recovery. We have to understand how Japan triggered this recession. We have to understand how the supply demand relationship shifted. It wasn't just the Federal Reserve that raised rates. The entire world raised interest rates in synch. The slowdown arrived in due course as planned. OPEC was blindsided by Japan also. We had a spike in oil prices just around the time the world economies were slowing. What that did was act like a tax on consumers and businesses. The IT sector expected to have continued growth. They thought they were immune. Corporate prices always fall in a slowdown. Corporations cut expenditures like advertising and capital investment and if IT is half of capital investment, IT capital expenditures are bound to fall. Because the expectations were for continued exponential growth and the reality was a drop in IT expenditures, It increased the gap, and that brought about the IT implosion. That added to the sharp slowdown to cause a recession. Until we understand how Japan was the first catalyst, until we understand that and how important the global economy really is, we'll continue to make mistakes and misjudge these things and the risk of more boom and bust will persist. Most major bear markets are associated with recessions.
AT: I hope that investors have benefited from your insights and have learned those lessons. I appreciate your time and your generosity.
AB: It's my pleasure. Thank you for having me.