That's the Signpost Up Ahead - Recession

by: David Andrew Taylor

I wrote a couple of days ago about the inverted yield curve. The yield curve showed that any time we saw the yield curve go down to 0 or beyond (in the negative numbers) then there was a recession that followed some time after. The most recent recession (of 2001) was preceded by the inversion by a few months. Nonetheless, the inversion pulled through. Because of that, I am pretty firmly entrenched in the idea that we are going to see another recession. This makes a lot of sense considering our economy has been running on ultra-high-octane fuel for some time, compliments of Greenspan, and is now finally up to what would be normal interest rates. Some declining ins expected with that type of economic policy.

The questions, then, are: When, and how big?

Glad you asked. Let's first take a look at our historical perspective to get a better grasp of the why and why of the coming recession.

Being firmly entrenched in Keynesian economics, I see a strong correlation between the rate of growth in income and the rate of growth in consumption. This makes perfect sense as there is, for the most part, a 0% savings rate here in America. Whenever there is an increase in income, there is an increase in consumption. So, I outlined my viewpoint with average hourly earnings, and consumption once before, but, here's another look at the chart.

The correlation between the two is very strong, save for three tax cuts that sent consumption up without any increases in average hourly earnings. What I want you to look at is the area that is above the yellow square. Here is another timeframe where average hourly earnings have gone down, but consumption moved higher. In this case, much higher. There is a simple explanation for this. Here is a chart on mortgage applications. More specifically, this is the REFI index:

That huge spike up? That was the very beginning of the move upward in consumption (whilst earnings were going lower). The mortgage chart is a weekly chart, whereas the earnings/PCE chart is a monthly chart. But, if I were to overlay the two, you would see a direct correlation to the spikes up in REFI applications and consumption. All the while, earnings were going lower.

That's what has been propping up the economy. But, where to now?

To begin, earnings are heading much higher. That, of course, will have a direct effect on consumption, which in turn will have a direct effect on growth. But, there is a small lag. We may not see this move up for a couple of quarters until consumption begins to pick up again. Until then, the positive GDP that we saw this morning could be threatened to move lower. We've already seen a decline in Durables just last week. That decline was for the first month of the third quarter. Another decline or two, and we're on our way to our first quarter of negative growth. Beyond that, there may be a stabilization in growth and increase from the third quarter. But, then it may also be a factor of future interest rate moves here in the states. This will be all the way into the second quarter of 2007. By then, the Fed will have all the information that is necessary for them to know if the lagged interest rates are going to be enough to contain inflation or not. See, if consumption kicks in because of the average hourly earnings increases, then any inflation that was abated due to aggregate demand is now probably going to be heading back up higher. That will prompt the Fed to move more on rates in the future. That is likely to come up during meetings around the first of the year.

So what I am looking for is what is happening with consumption, and its subsequent effects on aggregate demand. If there is no pause in the growth of inflation because demand kicks back up, we're going to be seeing more interest rate hikes.

Let's hope not, or the Fed will continue with their interest rate increases and kill this economy in the process.

The next few month's data is going to be interesting, and crucial.