Thursday, June 18, 2009

A Period of Economic Transition

With the prevailing wisdom pointing toward an economic recovery in the near future, the economy is likely entering a transitional period. The longer than average recession will probably mean a longer than usual transitory period. James Picerno from The Capital Spectator discusses what this transitory state could look like.

Flat to a slight upside bias. That about sums up the prevailing state of inflation at the moment, based on this morning's latest from the U.S. Bureau of Labor Statistics.

Seasonally adjusted consumer inflation rose 0.1% last month, up from zero the month before and a modest decrease in March. On its face, that's good news, as it suggests that the risk of deflation, if not quite passed, is looking more and more like a shadow of its formerly threatening self. Meanwhile, inflation as a clear and present danger also remains thin as an imminent menace.

We are in a transitory state, passing from severe danger to something less so. Anything's possible, of course, especially in the current climate. But barring some extraordinary and largely unexpected event, we're likely to press on through what we'll call a pre-recovery period, when the economic numbers improve relative to the recent past yet the numbers don't quite show the traditional bounce that typically accompanies the end of recessions.

"The economy seems to be out of intensive care," says David Shulman, senior economist at UCLA Anderson School of Management. "The freefall stage in dropping output and employment seems to be over, but the economy is still sick."

The prospect of false starts in the data looks quite high in the months ahead. The good news on one day will be reversed by bad news the next, and quite a bit of treading water at other times. The transition state that carries us from recession to growth, in short, will last longer than usual. The evidence will be particularly obvious in the lagging indicators, employment being the most conspicuous example. Indeed, the labor market is still shrinking and will probably continue to do so in the months ahead, perhaps followed by an extended bottoming-out period over several quarters. The economy's capacity to create jobs is likely to come later and be more tepid than has typically been the case following the end of recessions in the post-war era.

Extending the medical metaphor, Bruce Kasman, chief economist for JPMorgan Chase, predicts in yesterday that "the economy will return to growth but not to health."

Last week we wrote of the "technical end" of the recession and our expectation that NBER would eventually get around to declaring the downturn's finish at, well, right about now, give or take a few months. That's good news relative to the recent standard of economic activity. But the technical demise of the recession isn't likely to bring easily recognizable good news on Main Street anytime soon.

As frustrating as that outlook is, it's even more hazardous than is generally recognized. If we're facing an unusually long transition period, there are specific risks linked to this abnormal state of affairs. That includes figuring out how and when to adjust monetary policy to balance two conflicting forces: deflation and inflation. As the former gives way, the latter isn't likely to suddenly pop out and yell "boo." Nonetheless, the future inflation risk isn't trivial, given the massive liquidity that's been created of late and the historical lessons that go with fiat currencies. As we discussed on Monday, the elevated risk this time around will be one of deciding magnitude and timing in adjusting monetary policy going forward. That's always a challenge, although it's likely to be especially problematic in the quarters ahead. Tightening monetary policy too soon may risk choking off a nascent but weak recovery; waiting too long to raise interest rates may give inflation a solid foundation to thrive, an especially troubling thought, given the massive amount of debt incurred over the last 12 months or so.

Overall, economic analysis faces unusually tough times in reading the incoming data and drawing reasonable conclusions about the implications for the future. As a basic example, our proprietary index of economic indicators, published in each issue of The Beta Investment Report, is currently flashing a robust sign of recovery, although this may be misleading because much of the rise has come from monetary policy and, so far, isn't convincingly corroborated in the real economy.

In short, interpreting the economic outlook promises to be quite difficult going forward, much more so than usual. Beware: The risk of false dawns is rising.

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