A Framework That Provides Clarity

During periods of “low visibility,” confusion reigns: for every indication of one trend, there seems to be a countertrend. The key is to glean from the collective wisdom of reliable leading indicators a clear signal that the economy is headed for a turn.



Forecasting Fog

The American economy certainly isn’t at peak strength. With unemployment at a painfully high 8.6 percent, it can’t be. But unless the economy receives another shocking blow, it isn’t in imminent danger of relapsing into recession.

That was essentially the outlook presented by Federal Reserve policy makers last week when they ratcheted up their assessment of the nation’s economic condition. They concluded that the economy is on a path of moderate recovery, so the Fed needn’t take further action right now.

That relatively sanguine appraisal also appears to be the consensus of most private economists and Wall Street strategists. “The best case appears to be a ‘muddle through’ outcome in which the U.S. maintains its current growth rate,” as Barclays Capital put it recently in its annual report on the global outlook.

Such views represent economists’ best efforts to predict the future. But how much credence should they be given? After all, a vast majority of economists, including those at the Fed and in the White House, didn’t foresee some of the most crucial developments of recent years, like the severity of the subprime mortgage crisis and the housing market’s decline, the onset of the financial crisis and the Great Recession, and the weakness of the subsequent recovery.

In this season of forecasts and predictions, it’s certainly worth remembering that navigating the economy of late has been like driving in a dense fog. In such conditions, when you don’t really know what lies ahead, it’s wise to proceed with utmost caution.

Let’s look at a few reasons to be skeptical about the “consensus” forecast:

First, not everyone subscribes to it. As I wrote in a recent column, the Economic Cycle Research Institute, an organization with an excellent track record, says the United States is actually heading into another recession, if it isn’t in one already. The institute was founded by Geoffrey H. Moore, an economist who helped originate the practice of using leading indicators to predict business cycles. It bases its conclusion on a series of proprietary indexes.

In an interview in the institute’s office in Midtown Manhattan, Lakshman Achuthan, its chief operations officer, acknowledged that recent data, like the drop in the unemployment rate from 9.0 percent to 8.6 percent, have been positive. But this doesn’t alter his view. He said the institute’s leading indicators — which incorporate data on purchases, inventories, credit, business and consumer confidence, housing, real estate, global trade and profitability — unfortunately continue to signal recession.

“It’s normal to see data that seems reasonably strong even when a recession is just getting under way,” he said.

Next, examine the Fed’s own projections. In a statement at the end of the Federal Open Markets Committee meeting last week, it said the housing market — usually an important component of a recovery — remains moribund. Moreover, it said, economic growth will be too anemic to have a low unemployment rate anytime soon. In this vulnerable time, “strains in global financial markets” — read, turbulence in the euro zone — pose a serious threat, it added. A financial shock could darken the outlook immediately.

Then consider the private consensus. Economists polled in December in the Livingston Survey of the Federal Reserve Bank of Philadelphia downgraded projections made only six months earlier, by estimating that real G.D.P. in the second half of this year would rise at an annual rate of only 2.5 percent, not 3.2 percent. For the first half of 2012, they project an increase of only 2.1 percent, down from 3.0 percent. These forecasts could rise again, of course — but could also easily fall again.

More troubling, the forecasts of both the Fed and private economists have been way off the mark in recent years. For example, in December 2007 — when the Great Recession started, as we now know — most economists inside and outside the Fed believed the economy was still growing. Livingston Survey economists at the time predicted growth in real G.D.P. of 1.9 percent in the first half of 2008, with a jump to 2.8 percent in the second half. Fed staff economists made a similar forecasting error, as Simon Potter, director of economic research at the New York Fed, documented in a recent blog post.

Perhaps even more disturbing is that on June 9, 2008 — in the middle of what would be the longest and deepest recession since World War II, Ben S. Bernanke, the Fed chairman, said he thought conditions were improving. Remember that Mr. Bernanke is a distinguished economist with a vast array of information at his disposal. Yet he said in Boston, “The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.” In fact, the housing crisis was deepening, and the financial system and the economy would soon go into a tailspin.

Some of this is entirely understandable. After all, even predicting tomorrow’s weather is risky. Will it rain? Will it sleet? Will it snow? Often, we don’t know until the last second. Why should policy makers be expected to accurately predict the combined behavior of millions of people and enterprises in a complex and global economy, months in advance? Try they must, but perhaps it shouldn’t be surprising if the effort often seems little more than highly educated guesswork.

WHAT may be less obvious is that it’s not only predicting the future that’s difficult; measuring economic activity that has already happened is a Sisyphean task. A seemingly simple benchmark like the quarterly G.D.P. growth rate is published and revised seven times by the Bureau of Economic Analysis. Those revisions are sometimes significant, particularly at turning points in economic growth.

“When you’re building forecasts on a baseline that’s shifting, it can be very, very difficult,” said Steve Landefeld, the bureau’s director, in a phone interview last week. Brent Moulton, an associate director, explained that G.D.P. is a statistical compilation of data from about 200 surveys from 38 federal agencies, plus myriad private reports. The numbers are changeable.

And following them too closely can be misleading. On Aug. 28, 2008, for example — now known to have been the eighth month of the Great Recession — the stock market rallied on an upward revision of the G.D.P. from April to June, perhaps feeding into a false sense of security. As it turned out, that number was later revised downward, as was the G.D.P. for the previous quarter.

Research by Jeremy J. Nalewaik, a Fed economist, suggests that another measure — gross domestic income — has provided a better indication of where the economy has been heading in recent periods. Right now, it may be signaling trouble ahead — though the research so far is inconclusive.

It’s possible the fog will lift and we’ll find ourselves in a splendid period for the United States economy, which has lately seemed stronger and more resilient than those of many other parts of the world. But we don’t really know.

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