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Information Source: Nouriel Loubini's Blog:
Given the recent flow of dismal U.S. economic indicators (Q2 GDP report, July payrolls, service ISM, etc.) I am now taking the view that the odds of a U.S. recession by year end have increased from my previous 50% to 70% now. While I have been arguing for the last few months that the risks of a U.S. recession are growing, most investors and the Fed are still in a delusional mode of denial and believe in four fairy tales that are now, unfortunately, slipping by the moment into the dustbin of wishful dreams:
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Fairy Tale # 1: The U.S. economy will have a soft landing: according to this tale, U.S. growth will continue at its trend rate of 3.5% (as recently argued by Bernanke) or just below trend, around 3.0% (i.e. the Fed staff and the market consensus view).
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Fairy Tale # 2: If the U.S. slowdown is excessive, inflation will ease and the Fed will come to the rescue with a sharp cut of the Fed Funds rate in the fall. I.e. a reduction in interest rates will prevent a recession from occurring.
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Fairy Tale # 3: Even if the U.S. slows down, the world will "decouple" (to use Goldman Sachs' term) from the U.S slowdown and will keep on growing at a perky rate in Asia, Europe, emerging markets and Latin America. In JP Morgan's terminology, this "decoupling" is termed as the "rotation in global growth", from U.S. to Asia and Eurozone. Others refer to it as the "locomotive switch” with a switch in the global growth locomotive from the sputtering U.S. one to the perky ones in EU and Asia.
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Fairy Tale # 4: The rebalancing of global current account imbalances is underway and will be orderly rather than disorderly: the Bretton Woods 2 regime of vendor financing of the US twin deficits will continue unabated; and any possible fall in the US dollar will be orderly and gradual.
I have spent the last few months debunking these four fairy tales (see my recent blog writings here and here and here and here and here and here). But now some elaboration is needed as more market folks starting to get a reality check into Fairy Tale #1, but they are still in denial mode by believing in Fairy Tales #2, #3 and #4.
So, here are Five Ugly Realities that will determine the coming U.S. recession, the Fed failed policy response to it, the equity and financial market implications of it, the global economic consequences of it, and the disorderly rebalancing of the unsustainable global current account imbalances.
Ugly Reality #1: The Probability of a U.S. Recession is now 70%.
I had been predicting since last fall a sharp U.S. economic slowdown in the U.S. in 2006; I changed my call last June to one of an outright recession - with 50% odds - by early 2007. Given the flow of data of the last few weeks - effectively all of them heading south - I now am increasing my subjective odds of a U.S. recession by year end to 70%. I have reviewed in my latest writings the flow of macro indicators for the U.S. economy: both their headlines and details are simply ugly. At these indicators suggests that the Three Ugly Bears that I warned of since last fall are becoming uglier by the day: the housing slump is becoming a real bust; oil is headed higher and higher and could be soon well above $80; and inflation – both core and headline - is rising further forcing policy makers across the world to increase interest rates. Housing alone is now enough to cause a severe U.S. recession since, as I have argued:
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it directly reduces aggregate demand (residential investment will fall at an annualized rate of 15% for the next few quarters);
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it has a strong direct (wealth) effect and indirect (via Home Equity Withdrawal) effect on consumption;
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it reduces employment as 30% of the growth in payrolls in the last few years was directly or indirectly due to housing.
On top of the housing bust, the rising oil prices are adding another severe stagflationary shock to the economy. And the interest rate increases "in the pipeline" (to use the Bernanke term) still have to negatively affect the economy as the economy today is reacting - given the long lags of monetary policy - to the effects of a Fed Funds at 4%, not the current 5.25% whose effects will be felt only in 6-9 months.
The growing awareness that we are not going to have a soft landing but a severe recession is now clearly spreading among economist, market folks and, even, some policy makers. Last week, super-blogger and leading macroeconomist Brad Delong warned of a recession and even a possible "meltdown". Today, Paul Krugman in the New York Times picks up the theme with the subtle headline "Intimations of Recession" and the not-so-subtle concerned text starting with "Suddenly people have started talking seriously about a possible recession. And it’s not just economists who seem worried." Also today, the Financial Times is covering the wide-ranging debate in the blogosphere on my recession call. While Rich Miller on Bloomberg headlines with "
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