By Edward Lambert
I woke up today to see oil below $27 a barrel, the US 10-year at 1.6% and the Dow down to 15,600. How quickly the economy is faltering. It is a crazy moment. Oil below $29 a barrel creates geopolitical tensions that can create attacks of aggression. Other countries have already tried to negotiate with the Saudis to raise oil prices... and now oil is slipping to even new lows. A tense situation for oil producers.
The US 10-year hitting 1.6% so fast over the past month seems to be building downward momentum. The yield curve is trying hard to flatten even with short-term rates near zero.
Recession seems imminent. Will it happen? I called a recession this year based on my assessment of effective demand. Others like Tim Duy and Janet Yellen do not see a recession this year. But they lack an understanding of effective demand. I have seen this coming for a couple of years.
Back in September of 2013, using my Aggregate Supply-Effective Demand model, I saw that an effective demand limit was forming at a Real GDP around $16 trillion (2009 $). The AS-ED model was only developed in April 2013.
Here is an image from a post back then:
I saw that the effective demand lines were bunching together, setting up a long-run aggregate supply zone around $16.1 trillion, where the aggregate supply and effective demand lines would meet.
I wrote in September 2013:
"The blue dots along the bottom are real GDP on the aggregate supply curves increasing at an inflation rate around 2%. Real GDP will most likely continue this path over the next year, shown by lower dashed black line. The dashed black line above shows the effective demand limit coming steadily downward toward the LRAS zone. (LRAS is long-run aggregate supply). Real GDP and effective demand will meet at the LRAS zone. What will happen when they meet? ... If real GDP keeps growing at around $100 billion per quarter as it did in 2nd quarter 2013, real GDP will enter the LRAS zone in mid 2014."
The recession of 1980 followed the same pattern. The effective demand lines had been pointing toward an effective demand limit for three years since 1975. Then Real GDP hit the ED limit in the third quarter, 1978. A recession began to form and was official two years later (Note: The red dots in this graph show Real GDP moving with core inflation).
Eventually in a post in August of 2014, I projected:
"The projection now is for real GDP to enter the zone of the effective demand limit between $16.000 trillion and $16.160 trillion. This will happen before 2014 ends assuming the calibration of 0.762 for effective labor share is within a close margin of error."
So what happened?
Update Note: The red dots in this graph show the crossing points between aggregate supply and effective demand. These red dots are different from the red dots in the previous graph. These red dots show the equilibrium so to speak between aggregate supply and effective demand. In both graphs, the crossing points expanded upward as Real GDP hit the effective demand zone (LRAS).
The equilibrium points began to rise when Real GDP hit $16.1 trillion. That is a sign of hitting the effective demand limit. This happened before the end of 2014, just as I had predicted. When effective demand rises in the LRAS zone, the dynamics of the economy are on the downside of the business cycle, just starting downward.
Ever since the end of 2014, the economy has been faltering. I predicted that the Dow would orbit 17,300 through 2015. And it did. I gave a 70% chance of recession this year back in January (see comments).
If this cycle is like the cycle before the 1980 recession, we would see a recession about two years after hitting the effective demand limit... That would put a recession this year, 2016, in the summer or fall.
So I got glimpses of the effective demand limit upon Real GDP as early as September 2013. We have seen this coming for years.