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August 31, 2005
Katrina and the probability of recession
Kash returns from his hiatus and tries to discern the "animal spirits." He's worried.
Even temporary problems can get magnified if they contribute to a broader change in psychology. And I think that the current situation contains the seeds for such a shift in sentiment. My personal odds for a recession in 2006 have just gone up, thanks to Katrina.
James Hamilton tries not to be too pessimistic, but finds it hard.
Could this be enough to tip the whole economic cart over? I'm not certain that it will. But it would seem foolish to deny the very real possibility that it could.
Macroblog presents a special mid-week edition of the fed funds probabilities and reports that sentiment for a November rate hike is weakening.
David Tufte thinks the damage total will be much higher than the media is reporting, and he's pretty familiar with the area.
The only estimates that have come out so far are insured losses. There are three problems with this. First, New Orleans is not a heavily insured city. Second, initial insurance estimates have been notoriously low for several disasters the last few years. Third, we've never had a disaster like this before.
Estimates of national wealth from the World Bank are $400K per capita in the U.S. Currently, with the failure to close the 17th Street levee break in New Orleans, the entire east bank of Orleans and Jefferson parish is at risk. Something like 800K live in that area. This places the total wealth of that are at $320 billion.
and...
On top of this, the GDP of the east bank is roughly $2.5 billion per month. They are talking a bare minimum of 2 months before people can even come back everywhere across the city, much less get back to a reasonable facsimile of earlier production.
Calculated Risk gives the rundown on the refineries.
MaxSpeak thinks it might be too late...
Oil refining capacity is on a very tight string. Any damage in the Gulf seems likely to wreak non-trivial damage on the economy. That sounds like an emergency.
But it may be too late to prevent a recession, given the heights to which oil prices have already risen. Is a recession an emergency? How much would releasing the reserve do to forestall gas price increases and recession?
Like I said last night, I am reluctant to speculate too much too soon about a recession. It's just too early. But all in all, the economics corner of the blogosphere has been (as evidenced by the links here) very reasoned in its assessment of the situation. My take is closest to Hamilton's. It would indeed be foolish to underestimate the possibility that this could be the straw that breaks the camel's back. For some time, I have been comparing the present situation to the mid-1990s, which was a time of monetary tightening, the early stages of a recovery, much anxiety over deficits of both the budget and the trade variety, and a general notion among economists and analysts that the economy was at a crossroads. Will the landing be soft or hard? That was the question then, and it is the question today. I have been of the opinion that if we are able to stay the course, we would be on a trajectory for a soft landing, perhaps even softer than in 94-95. My airplane analogy even got a notice from Brad DeLong. Well, to continue the analogy, this hurricane was indeed the sort of ill wind that would cause a pilot to make a last minute correction or things will get bumpy. I think it is reasonable to believe such a correction could take the form of a pause in rate hikes near the end of the year. I've been arguing that even before the hurricane, and I believe it even more strongly now. I know we'll be watching those fed funds probabilities very closely, eh, David?
Of course, that doesn't mean a recession is inevitable. After all, we had the Mexican peso crisis in late 1994 which some thought might derail our nascent recovery. It did not. Will Katrina be different? As of August 31, we simply cannot say. I think it is safe to say, however, that this is a very critical moment for the economy. It could swing either way. If we pass this hurdle, I think it bodes well for the future of the recovery.
In the immediate term, my thoughts and prayers are still with the people affected by Katrina.
UPDATE: David Altig posts an update on the fed funds probabilities, and all I can say is, "Wow." Altig writes,
In his email alerts, Stan Jonas -- who probably knows more about the federal funds rate derivatives than anyone -- says "Fed Done By December... Certain..."
Posted by William Polley at August 31, 2005 04:33 PM
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Comments
The key question is what does all this do to consumer confidence and spending plans for X-mas.
For this reason I do not think the peso crises is a good analogy as the public was generally not impacted by it. But retailers have already placed orders for a good X-mas and the goods are already in the pipeline. The odds of a poor
X-mas leaving unsold inventories are rising sharply and this is where the major risks of recession emerges. Recession occur when business makes a mistake, that is why it is extremely difficult to get large models or the consensus to forecast a recession.
Posted by: spencer at September 1, 2005 12:08 PM
It turns out that the public was not terribly impacted by the peso crisis, but at the time the concern was there. For example, look at this Dallas Fed publication talking about the peso crisis in early 1995.
"This dramatic devaluation should have few long-term effects on the level of U.S. employment, but it could have a substantial influence on the kinds of jobs people do and where they do them. Nowhere will these shifts be more evident than in Texas."
http://www.dallasfed.org/research/swe/1995/swe9501.pdf
Largely temporary and regional effect. Sounds familiar. Obviously the situation was very different in many important ways, but there was definite concern. Ditto for the Asian Financial Crisis. One could even draw some parallels to 9/11. My reason for using the peso crisis was one of timing. We were in a similar situation in the middle of a tightening cycle. In 94-95, the FOMC met via conference call twice about the peso situation. There were obvious concerns for financial market throughout Latin America which, if things went sour, would have impacted our markets. In the end, it turned out to impact neither the ultimate course of interest rates nor consumer spending all that much. You will understand that it is my sincere hope that things turn out that well after Katrina.
But they may not, in part for reasons you and others are raising. It is extremely difficult to make recession forecasts, especially when we are at "crossroads" moments like this. And I assert that 1994-95 was one of those moments. Different in many ways, to be sure. But probably the best example in recent memory of a similar point in the cycle.
Posted by: William Polley at September 1, 2005 01:51 PM