Are We Headed Towards a Recession?

by: Jim Kingsland

Accurately predicting a recession is about as easy as pinpointing the landfall of a hurricane several days out. That's still not stopping CEOs, government leaders and economists on both sides of the fence from weighing in on the matter with increasing frequency.

The U.S. economy with a $13-trillion output of goods and services, as guaged by Gross Domestic Product, or GDP -- is not only the world's largest economy, but thus far has been a reslient economy.

This week the government released its second estimate of growth during the second quarter of the year. A rapid 4% growth rate was reported. The second quarter seems like the distant past as the "perfect storm" of events has converged to threaten future economic growth.

The problems range from a rapidly declining housing market, wild stock market swings, to credit market turmoil which is drying up financing to a wide range of consumers and businesses -- far beyond the original flash point of defaults by subprime borrowers.

The slump in the housing market and the loss of easy credit has sparked worries that consumers could take the economy over the edge if they become tapped out, or become vulnerable to job losses.

Consumer spending accounts for about 70% of GDP and during the housing boom - they felt wealthy because of cash from the home equity ATM and a wealth effect from rising home values. Now the housing ATM reads 'insufficient balance' and the wealth effect from rising home prices is all but a fond memory.

"Out there, there will probably be some kind of recession, whether it's a year or so, I wouldn't know, I'm not a trained economist," says John Bogle, founder & former CEO of The Vanguard Group. But Bogle, who points to "cycles that come and go" as reason why things will turn negative, assigns about a 75% chance the economy will contract, but didn't say by how much.

A text book definition describes a recession as two consecutive quarters of falling GDP. The National Bureau of Economic Research, also known as NBER, goes a few steps further: "A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales." The NBER is the group charged with officially declaring the start and end of a recession -- the last one being in 2001.

Optimists, however, remain. At the U.S. Chamber of Commerce, it's chief economist doesn't see a recession over the next 12 months.

"It's clear over the last year-and-a-half the economy has downshifted and things are not doing quite as well. But having said (that), I don't think we're on the precipice of a recession," said Martin Regalia, vice president for economic policy at the U.S. Chamber of Commerce. Regalia remains in the camp that sees defaults in subprime mortgages as a largely contained event that won't spread to broader housing and lending markets.

That view is in stark contrast to chief executives like Michael Jackson of AutoNation who sees a crimped consumer. "You're 17 rate increases have worked, mission accomplished," said Jackson of what he would advice the Fed to do. "Be careful, you've brought recession into play here. From my 40 years in the business, I look at the American consumer. They've pulled back, and everytime they pull back you bring recession back into play."

Most economists are unconvinced that recession is on the horizon. The consensus forecast of 50 top economists surveyed in early August for the Blue Chip Economic Indicators report called economic growth to slow but see it remaining above 2% through the end of 2008.

"The consensus of economists has never forecast a recession. That doesn’t mean individuals haven’t, but the consesus forecast tells you little," says Paul Kasriel, chief economist of Northern Trust. "The consensus always ends up being surprised."

Kasriel uses two indicators that he says are both flashing a "recession signal." "My first indicator is simple and has correctly called recessions since 1970 with no false readings," says Kasriel.

His indicator looks at two variables. One is the spread between 10-year treasuries, and the Fed Funds rate. The other tracks the Fed's monetary base.

The first says, Kasriel is "negative with fed funds above the 10-year treasury, and the quarterly year-over-year change in the Fed's monetary base is contracting" When both those conditions exist, it suggests that a recession is on the way, according to Kasriel.

His other indicator is looking at the Index of Leading Economic Indicators, or LEI. Kasriel says the quarterly year-over-year change in the LEI has been negative. He says that indicator has worked over the nearly five decades with the exception of a period in 1967.

Kasriel notes that while the bulls will try to celebrate Thursday's likely upward revisions to the 2nd quarter GDP, "it's just a look back and that things can change very rapidly."

He also cautions that weakness in personal consumption in the 2nd quarter report was a noticeable red flag, running at just above 1%.

While he doesn't think we're in a recession now, he says we're on the "cusp" and said there have been past instances where economic growth has been strong one quarter, and the next quarter would mark the start of a recession.

Thanks to housing, a recession is not far away.