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Tuesday, June 27, 2006

Merril Lynch: 40% Chance of Recession by early '07

by Calculated Risk on 6/27/2006 06:09:00 PM

From Reuters: Chances rise for housing-driven recession

Merrill Lynch economists say there is now about a 40 percent chance of a recession in the first half of 2007 -- even without a widely anticipated 25 basis-point Federal Reserve rate hike this week.
...
Bernard Baumhol, executive director of The Economic Outlook Group in New York, said he believes chances of a recession in 2007 will increase to 35 percent if the federal funds rate -- at 5.0 percent going into this week's Fed policy meeting -- exceeds 5.5 percent.

"If the Fed gets to 6 percent, we're probably talking about a 50 percent probability of a recession in 2007," Baumhol said.
In the comments to an earlier post, bbb provided links to this recession calculator (based on a method outlined by Dr. Hamilton):

Reckoning the Odds of Recession

Visualizing the Probability of Recession

Using these tools, and values of 5.21% for the Ten Year, 5.05% for the 3 month, and 5.25% for the Fed Funds rate (expected), yields a probability of recession of 32%. That is the odds that America is in recession right now.

I am not ready to predict a recession, although an economic slowdown seems certain. On the other side, from the Reuters article:
'A housing-driven recession is "mathematically impossible," said Wachovia Bank senior economist Mark Vitner, because housing is derived from the rest of the economy and construction is actually a smaller portion of the U.S. economy than during the housing boom of the late 1970s. Even if home values soften in expensive markets, many homeowners are still sitting on substantial home equity cushions.'
Actually housing is a much larger percentage of the economy than in the late '70s. Using data from the BEA:


Click on graph for larger image. Note: 2006 is estimated from Q1 data for both graphs.

Residential investment is a larger part of the economy now than in the late '70s.


And from the Federal Reserve Flow of Funds report:

Mortgage debt as a percent of GDP is significantly higher now than in the late '70s.

And finally from the BLS, construction employment is higher now, as a percent of total employment, than in the late '70s. From '76 to '79, construction employment was 4.7% of total non-farm employment. Today, construction employment is 5.5% of total employment.

Although wrong on the facts, Mr. Vitner is correct that a housing slowdown alone has never taken the economy into recession. And that is one of the reasons I've been hesitant to forecast a recession.