One of the reasons economics is known as “The Dismal Science” is that it has an absolutely dismal forecasting record. Why? Well, an economist’s business often requires him to emphasize the short term. At the same time, most economists do not want to stray too far from the consensus opinion since if they do—and are wrong—they might lose their jobs.

Last year however, we deviated significantly from the consensus opinion and saw a set of circumstances so compelling that it led us to forecast—very much counter to the consensus at that time—that the economy was likely headed for recession. Here’s why: There were three major forces at work against the economy, and as the mosaic of economic indicators confirmed their effects, a story started to fall into place and virtually tell itself.

First, inflationary pressures were starting to bubble. As early as May of 2004, the Federal Reserve warned economy that was growing too fast and started to raise the Federal Funds interest rate. When the Fed starts to raise interest rates, alarm bells should go off, loudly, because it means that the Fed is proactively trying to slow the economy. The record is very clear that Fed actions work, but they work with a very long lag of between three to five quarters (meaning a slowdown starting at the end of 2007).

At the same time, in May of 2004, the price of crude oil broke through a record high, which had stood for 14 years, and then really took off. Every time there has been a spike in oil prices in the last thirty years it has been followed by a recession.

Then in August of 2006, the median sale price for an existing home fell on a year-over-year basis for the first time in 11 years (home prices had fallen in only five months over the past 37 years that records have been kept). They continued to fall in September and October (that month it was a record, -4.2%). This was an unprecedented event, so alarm bells went off yet again telling us that there was a serious change afoot, and in this case it was the bursting of the housing market “bubble.”

So by the summer of 2007, there were three negative forces at work on the economy: tightened monetary policy, high oil prices, and a deflating asset bubble. Each of the three had been associated with recessions in the past, and now all three were at work at the same time. Since then the “sub-prime” and other debt crises have emerged. We don’t think there’s much doubt that the domestic economy is in a recession.

How do these forces impact trade? As the Fed continues to lower interest rates and virtually disavows any support for the dollar, it’s quite likely that the dollar will continue to crumble, much to the benefit of net exports. And just as Fed actions take a long time to affect the domestic economy, changes in foreign exchange rates take a long time to affect external trade so even if the dollar were to reverse course tomorrow, it is unlikely to significantly affect trade for several quarters.

The real question now is what happens next? It’s likely that the recession will end when the housing market stabilizes and when monetary policy easing takes full effect. Industry leaders now think that the housing market will likely come out of its slump by late 2008 or early 2009. The Fed’s interest rate cuts, begun last September, usually take around a year to work, so we anticipate the stimulus to kick in by Q4 2008 as well.

Therefore—to go out on another limb—it would seem to us that the economy might suffer two or three quarters of negative growth in 2008, with signs of recovery emerging by the end of the year.

The economy rides the business cycle, and it is now on the downside of the business cycle, entering recession. But the up side of the business cycle is coming too. We just have to wait a few quarters for it. wt



Dan North is Chief Economist for Euler Hermes ACI, a leading provider of trade credit insurance and risk mitigation solutions.