Editor's Note: Anirvan Banerji's column runs exclusively on RealMoney.com; this is a special free look at his column. For a free trial subscription to RealMoney.com, click here. This article was published Jan. 30 on RealMoney.
The long-awaited U.S. economic recovery is now at hand. That's the clear message from the array of leading indices maintained by the Economic Cycle Research Institute that first warned of recession 16 months ago and signaled its inevitability 10 months ago , right when the recession began. So what? ECRI might have been the first to warn of a recession, but many others have already called a recovery. What's different is that, as my friend Jim Grant put it, many of those optimists started predicting a recovery even before this recession had begun. In contrast, we correctly forecast not only this recession but also the last one -- which few anticipated -- as well as the subsequent recovery. In the intervening years, we didn't cry wolf -- in contrast with pessimists who wrongly predicted recessions in 1995 or 1998. We were able to do this because, as business-cycle economists, we had refined our indicators over many decades to forecast cyclical turning points with a high degree of accuracy. Many well-known forecasters work for public and private organizations that have a vested interest in good news. They are naturally reluctant to predict a recession but eager to forecast a recovery. At ECRI, we're forecasters, not cheerleaders. If we have any vested interest, it's in forecast accuracy. Our independence, our specialized expertise and our forecasting record, I submit, are what set us apart. And that's why, when ECRI predicts an imminent recovery, you should take it seriously -- whether you're a bull or a bear.
A First-Quarter 2002 Recovery
Before making any predictions, it's important to understand where we are in the business cycle. The way to answer this question is to look at ECRI's U.S. Coincident Index (USCI), which is designed to move in step with the economy. It peaks when a recession begins and bottoms out when the economy does the same. The latest data show that employment and industrial production, two key components of the USCI that are used to date recessions and recoveries, kept falling through December. In fact, the USCI itself declined in December, implying that the recession likely continued at least through that month. But we believe a recovery is imminent. Why do we believe the recession will end so soon when others think it won't end until the second half of the year? Our conclusion is based on ECRI's array of leading indices that collectively point to an early recovery. In particular, it's based on the Weekly Leading Index (WLI), whose cyclical upturns occur on average three months before the economy starts to recover. What's remarkable about the WLI's leads at business cycle troughs is how little they vary. In fact, in more than half a century, the WLI's lead has never exceeded four months. The WLI bottomed in October 2001. Since then we've become increasingly optimistic about the economic recovery . It's now clear that the WLI has risen in the pronounced, pervasive and persistent manner that marks a cyclical upturn. Thus, it's highly likely that the economy will begin to recover by the first quarter of 2002.
No Double or Triple Dips
There are those who concede that there could be a bounce in the first quarter but believe it'll give way to a renewed contraction. If so, the recession wouldn't really have ended -- it takes a sustained recovery for that to happen. We don't believe that scenario, because ECRI's U.S. Long Leading Index, which would be the earliest to spot such weakness, has shown no signs of faltering. Of course, if we're wrong, stock prices will plunge below their September 2001 lows and then turn up about four months before the eventual recovery. It's very unlikely that the September 2001 low in stock prices will correspond to a summer 2002 recovery, because that would make for a lead time of nearly a year at this business cycle trough. That's simply not how stocks behave. In fact, in four decades, the lead of stock prices at business cycle troughs has never exceeded five months. If the September low in stock prices holds, as we expect, the economy will bottom by the first quarter of 2002.
What Kind of Recovery?
At this point, there's little to tell us how long the coming expansion will last. After all, in the last 21 years we've seen both the shortest expansion on record, which lasted just a year in 1980-81, and the longest expansion ever, which lasted a full decade, from 1991 to 2001. The length of the next expansion is likely to be somewhere in between, but we simply don't have a good idea of its duration. What we do know is that this recovery will battle major headwinds. For instance, profits have plummeted during the current synchronous global recession while overcapacity has mounted, leaving firms with neither the wherewithal nor the incentive to drive a strong rebound in capital investment. The plunge in profits will also curtail new hiring, limiting the drop in unemployment during the recovery. This is likely to check the rise in consumer confidence, undermining the rebound in consumer spending. Not that consumer spending has plunged during this recession -- it can't really surge back, especially given the consumer's level of indebtedness. The ratio of consumer credit outstanding to disposable personal income, now at a record high, usually falls during a recession and early in a recovery. What we're likely to see, therefore, is a relatively gentle but sustained rebound in the U.S. economy starting early this year. As a result, the U.S. will act as a locomotive, powering recovery in many countries strongly dependent on exports to the U.S., such as Taiwan, Korea and Mexico. Missing from that list are two of the world's three largest economies: Japan, where the recession is set to deepen; and Germany, where a recovery is not yet in clear sight. The good news is that with much of the world continuing in recession, imported disinflation will keep U.S. inflation in check this year. Thus we should once again see a period of growth without inflation.