Reckoning

JACKSON HOLE, Wyo. -- Here's the forecast

Merrill Lynch

chief economist Bruce Steinberg was spinning back in October.

The winds of deflation are blowing through the world economy. ... Under these circumstances, the two Fed easings to date are just the prelude of more easings to come. ... We are again lowering our estimates of future economic growth and earnings. We expect U.S. gross domestic product to grow only about 1.5% during 1999, perhaps even less. As we explained last month, the Treasury yield curve may be the best predictor of recessions. Calculations based on current spread relationships indicate that the probability of a recession, negligible at the beginning of the year, is now 30% and rising.

The interaction of a profit squeeze and an incipient credit crunch is beginning to stifle growth and raise the risk of recession. An earnings slowdown usually leads to cutbacks in capital spending, and that process is already under way. A profit squeeze also eventually slows job growth and, therefore, consumer spending. Because the U.S. economy is now the most equity-linked economy ever, an earnings slowdown -- which also depresses the equity market and its wealth effect -- can now have deeper effects than in the past. At a minimum, the huge boost that consumer spending has gained from the market's wealth effect will dissipate.

The latest Fed survey shows that banks have tightened credit standards and are likely to tighten them further. Credit availability is being curtailed. ... We believe the Fed will be up to the task. We expect it and other Western central banks, even the European Central Bank, to aggressively ease policy, which will be critical. When lenders start running from risk, interest rates must fall sharply to stabilize growth. ... The fact that the yield curve flattened after the Fed lowered rates shows that a lot more easing is needed. ... By mid-1999, if not before, we expect the federal funds rate to be down to 4%. If that is not enough to put the economy on an even keel, the Fed will keep on easing.

Here are highlights of the forecast the folks at the

University of Michigan

were spinning back in November. (Note that Michigan puts out the

consumer sentiment index

, one of three main consumer confidence indices.)

  • Economic growth falls to 1.5% in 1999 from 3.9% in 1998.
  • The unemployment rate rises to 4.9% in 1999 from 4.5% in 1998.
  • The Fed forces down the funds rate a full percentage point, to 3.75%, by December.

In short, said the Michigan forecast chief, "This long expansion is heading into its slowdown mode."

The point here is not to hunt down poor forecasts and crucify the people who produce them. As fun (and lucrative, if you can believe it) as that is, it's hardly challenging; game is ridiculously plentiful in these woods (so much so that shooting fish in a barrel seems downright sporting in comparison). More important, it's just not fair. Every economic forecaster under the sun makes bad calls all the time.

It is entirely right, however, to question closely the thought processes that produced such forecasts. That's the point here: to dissect such thinking and to use the resultant entrails to figure out whether or not you ought to listen to these people anymore -- even if they tell you that the 1963 split-window

Corvette

was the best one ever made.

The Michigan forecast came -- and not at all coincidentally -- in the wake of a material and months-long decrease in the Michigan confidence index; it had fallen to 97.4 in October (its lowest level since December 1996) from 110.4 in February (its highest level ever). The thinking here was that shaky shares lead to nervous consumers lead to increased saving and sorrier spending numbers in no time flat.

The pedestrian nature of such thinking perhaps explains its popularity; even (supposedly) bright forecasters bought into the confidence thing hook, line and sucker.

The positively fetching thing about the confidence indices is that, over time, they correlate nicely with consumer spending -- and hence GDP (spending accounts for roughly 68.2% of GDP). Both Michigan and the

Conference Board

are constantly publishing neat charts to prove it.

Yet the ugly little secret here is that, over time, every variable in economics pretty much correlates with every other variable in economics.

It's always unwise to use confidence indices to predict spending -- especially in a short-term sense. They're just too volatile (note that the Michigan index has bounced as high as 108.1 since its all-time low in October). And even if they weren't, such an exercise boils down to first counting on (usually disinterested?) respondents to tell the whole truth, and then counting on them to act in a fashion precisely consistent with their responses. In short, it boils down to assuming that people actually go ahead and do everything they say they will do.

If the absurdity of that premise doesn't slam you in the face, then perhaps you can take comfort in an appeal to authority: No good forecasting model includes confidence as an explanatory variable anywhere. Not one.

Leaving aside a violent violation of the Paperwork Reduction Act of 1995, Steinberg ought to have been indicted on two counts. More forecasters than you suspect are guilty of Count One: Public Display of Gross Ignorance Concerning the Wealth Effect. Bright forecasters know that the wealth portion of the consumer's spending decision takes into account not what shares did last month, but rather what they have done on a cumulative basis over a number of years. (Does no one remember

Milton Friedman

?) Bright forecasters also know that it will take an unambiguously big drop in share prices (30%) that persists for a long period of time (six months) in order to get consumers to change their spending habits materially.

Dimmy-dim forecasters know neither.

Count Two: Jumping on an Unforecastable and Major Economic Event Because It Supports a Lousy Years-Old Forecast is the economics equivalent of abducting a child. That's how disgusting it is.

Steinberg had been forecasting slowdowns in all forms -- inventory slowdowns, housing slowdowns, employment slowdowns, consumption slowdowns and gross domestic product slowdowns -- since at least August 1997. Then came a four-sigma event whereby Russia devalued and defaulted, which led directly to a big hedge fund blowing up, which led directly to Fed easing.

As far as slowdown reasoning goes, this event proved exponentially more useful than the same stale Unsustainability Argument that had for years served as the hallmark of this crowd. (Why's growth going to slow? Just because. It's unsustainable.) And, especially in light of that hangdog yield curve, it was a no-brainer that the recession forecasts would flow like red from a split head.

And oh, they did, my brothers. Steinberg, along with wing-nut New Era types everywhere, rolled out the recession artillery. They told you that the chance of recession stood at 30% and provided updates every 2 percentage points; they warned that if the Fed didn't get just plain Japanese with the funds rate, we were all gonna die.

And most disingenuous of all, they said this:

See that? We were right about the slowdown all along.

Epilogue

Michigan has backed off on the slowdown thing. But look for a renewed effort once its sentiment index dips below 100.

Most wing nuts still cling to their slowdown forecasts; as has been the case for the better part of three years, they simply push them back yet another quarter when they fail to come to pass. They ignored facts last autumn -- money growth always slows before the onset of a recession; money growth was accelerating at the time, and the actions the Fed took were intended to accelerate it even more -- and they're still ignoring them now. Not one of them will grant, even now, that the last of the Fed's easings probably wasn't necessary. And they would still prefer that the Fed lower the funds rate. By a lot. And the sooner the better.

Sickest of all, the Steinberg growth forecast recently turned a 180. It's now one of the highest on the Street.

Our man found faith at some point during the past few months. Maybe he started looking at the numbers; it seems more likely that he saw Jesus in his tortilla.

But whatever the case, a reversal like that ought to worry us all.

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