Tuesday, July 15, 2008

Kasriel: Base Case vs. Checkmate

by Calculated Risk on 7/15/2008 02:15:00 PM

Note: the Northern Trust link doesn't seem to work. Here is the Kasriel July Outlook.

Northern Trust chief economist Paul Kasriel writes for July: Base Case vs. Checkmate

Our base case economic scenario is that the U.S. economy entered a recession in early 2008, will remain in a mild recession throughout 2008 and will begin to experience an anemic recovery in the first half of 2009. The base case includes a sharp deceleration in inflation in the not-too-distant future as energy prices stabilize and then retreat due to a slowdown in the growth of global demand for energy. The Federal Reserve will maintain the federal funds rate at 2% through the first half of 2009. In the second half of 2009, when economic growth picks up enough to stop the upward trend in the unemployment rate, the Fed will start raising the funds rate.

Our risk case scenario is that the U.S. dollar begins to fall precipitously coinciding with a rise in Treasury bond yields. U.S. inflation does not moderate because of the depreciation in the dollar. As a result, the Federal Reserve is forced to raise the funds rate even in the face of a rising U.S. unemployment rate. This would be “checkmate” for the U.S. economy, turning a relatively mild recession into a severe one.
Kasriel's "base case" is very close to my view; a mild to moderate recession that lingers for some time with a prolonged period of elevated unemployment. However I don't expect unemployment to reach 8%.

One of the keys to the base case is that oil prices decline in the 2nd half of 2008 (something I've been predicting for some time). This prediction is based on demand destruction, lower subsidies in certain Asian countries, weaker demand growth in China, and a few other reasons. The fundamentals of supply and demand for oil suggests a small decrease in demand could led to a fairly large decrease in price. If this happens, then that will hopefully lead to Kasriel's "sharp deceleration in inflation".

However, if oil prices increase or stay elevated, then the Checkmate case becomes somewhat more likely (although I still think it is highly unlikely). See Kasriel's piece for much more.