Economist thinks recession will next occur in two years

March 07, 2000

CHAPEL HILL -- Economic expansions never die of old age, a University of North Carolina at Chapel Hill financial expert says, and there's no reason why the current prosperity cannot last for another decade or more, but the odds are against it.

That's because the seeds for the next recession already have been sown.

"The best bet is that the policy mistakes that will stop the expansion and give us the next recession have already been made," said Dr. James F. Smith. "My forecast is that when we look back on the late 1990s we will find that the Federal Open Market Committee (FOMC), the arm of the Federal Reserve System that sets monetary policy, allowed the broad monetary aggregate known as M2 to grow too rapidly for too long in late 1998 and early 1999.

"They did this for a good cause, which was to try to reassure financial market participants who were rattled by the Asian contagion, the Russian default on Soviet-era debt and the debacle surrounding Long Term Capital Management."

Smith, finance professor at UNC-CH's Kenan-Flagler Business School and chief economist for the National Association of Realtors, described the national and world economies in the March issue of "Business Forecast," a newsletter he writes for UNC-CH. Twice in the past four years he was the nation's most accurate economic forecaster, according to The Wall Street Journal.

"History suggests that when the M2 money supply grows at a rate in excess of money demand for six months or more, then an increase in the rate of inflation will show up in two-and-a-half to three years," he wrote. "That lag ought to lead to increases in the consumer price index (CPI) getting close to 3 percent on a regular basis in early 2001."

Currently, the index is already rising at levels above 2.5 percent, but most of that reflects sharply higher oil prices from the same period a year ago, Smith said. Changes in the core rate of inflation -- a measure which eliminates often-volatile food and energy prices -- are what really matter.

"The FOMC has been moving in a series of steps to try to stay ahead of the curve of rising inflationary pressures," he wrote. "The new target for the federal funds rate, the rate that banks charge each other for overnight loans, was set at 5.75 percent by the FOMC on February 2. This is a full percentage point above the level a year ago but only one-quarter of 1 percent above the level of September 1998. Virtually all economic forecasters expect another quarter-point increase at the March FOMC meeting and quite possibly more later this year."

The yield curve for U.S. Treasury securities has a distinct hump at the two-year maturity, Smith said. That means that the highest yield is at that relatively short maturity and that one gets a lower return on investments by investing for any longer period.

"The yield curve is partially inverted and is a clear sign that bond market investors expect the economy to soon slow down quite a lot," he said. "However, at the moment there is no evidence of this at all."

No one needs to worry about the yield curve until it completely inverts, the economist wrote. Then the shortest maturities at which the Treasury regularly sells debt (the 91- and 182-day treasury bills) have a higher yield than all succeeding maturities. It produces a yield curve sloping downward to the right.

"Whenever you see this relatively rare phenomenon, which was last seen in 1989, and it persists for one month or longer, you can be virtually certain that the next recession will occur within 10 to 15 months," Smith said.

The signal has never appeared without being followed by a recession since the Federal Reserve System began in 1913, he said. Conversely, the last U.S. recession not preceded by an inverted yield curve for U.S. Treasury securities began in May 1923 and ended in July 1924.

"That was a classic inventory cycle recession and no analyst expects that phenomenon to trigger another cycle again," Smith said. "Modern inventory control methods, which seem to get better every day, make the need to rapidly get rid of suddenly excessive levels of inventory an extremely unlikely event. The inventory-to-sales ratio in December (1.32 months supply at current sales rates) was the lowest ever seen in the U.S.

"My forecast is that by early 2001 we will see the CPI consistently rising at rates 2.7 to 2.9 percent above the levels of the comparable month this year. Such a result ought to result in aggressive tightening moves by the FOMC in a series of steps."

At some point, bond investors will bid up the prices of longer term Treasury securities because they will be convinced that future inflation will be much less than current inflation, he said. As that occurs, the Treasury yield curve will become fully inverted.

"My forecast is that will happen in August 2001," Smith wrote. "If that comes true then you can be nearly certain that just as night follows day and day follows night, the next recession will arrive in 2002."
Note: Smith can be reached at (202) 383-1184 or (919) 962-3176. As time allows, he's willing to discuss most economic issues with reporters. E-mail:
Fax: (202) 383-7568.
Contact: David Williamson, (919) 962-8596.

University of North Carolina at Chapel Hill

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