Dr. Tucker Hart Adams’ economic outlook: A state of ‘unstable equilibrium’

Dr. Tucker Hart Adams made an early appearance and shared her insights on the national and Colorado economic outlook with over 200 attendees at CMLA’s October 5 luncheon. Dr. Adams began by sharing several trends that are affecting our current economy: 1) for almost two years after the recession officially ended we have continued to lose jobs; 2) little or no growth in wages and salaries after an adjustment for inflation; 3) debt has remained extremely high even after five years of expansion; 4) Federal government debt has continued to increase and is running at about 65% of output (which is not particularly high) - but to have these numbers during a time of economic expansion is troubling. Despite those factors, Dr. Adams noted, “The thing that worries me the most is consumer debt – mortgage debt, credit card debt, all types of debt that boosts the amount of after-tax income that must be used each month just to make the minimum interest payment.”

            Although the Federal Reserve raised short-term interest rates 17 times, long-term rates kept coming down. Today long-term rates are below short-term rates - what is referred to an inverted yield curve. Not so much in Colorado, but places like Las Vegas, Reno, Southern California, and Florida have seen home and condo prices soaring at double-digit rates month after month…until recently. “Those double digit rates sound great, but they are a matter of concern because of their relation to a lot of speculation in the housing market. We are seeing the first nationwide housing bubble in 75 years. There have been plenty of regional bubbles, but we’ve not had anything country-wide since the 1930’s in the Great Depression,” Dr. Adams stated.

            As she began writing her annual forecast, Dr. Adams began thinking about some concepts that she hadn’t really thought about since graduate school – concepts like stable and unstable equilibrium. Then she came across a term “unstable equilibrium” which she believes fits our economy today, as things appear stable on the surface, but they are actually in a state of disequilibrium.

            “Second quarter growth and output (world GDP) was not even half of what it was the first quarter of this year; at the end of the second quarter, heads of major corporations stated that not only are business co-commissions getting worse here in the United States, they are getting worse throughout the world,” she noted. “And there have certainly been signs the last two months of a correction in the housing market; sales and prices are down, and last month for the first time in a long time, a month-over-month decline in the price of existing homes became apparent. Employment in the construction industry is down, real residential investment (which is how housing shows up in GDP) is down and housing inventories and foreclosures are rising.

Dr. Adams also noted that consumer confidence has posted some sharp declines and retail spending is slowing; at the same time, debt continues to rise. Revolving credit (primarily credit card debt) was up 13% in June, up another 13% in July; payday loans are up 85% relative to a year ago. Core inflation and the personal consumption expenditure inflator is up 4% in the second quarter after declining steeply the previous three quarters, which means the Fed is concerned about inflation.

Last year Dr. Adams mentioned that she believed there was a recession on the horizon. “But I was cautious not to mention when I thought it would hit. This year I think it would be a bit irresponsible not to step up and put some numbers to my prediction. This year’s economic forecast is that the U.S. economy will be in recession before the end of the year and that the only real question is how hard will the landing be.”

Dr. Adams listed three candidates that she believes will lead to recession. The first has to do with interest rates. “The reason mortgage rates have been so low is because the foreigners who are receiving all those dollars we are spending on imports from other parts of the world are turning around and reinvesting that money in U.S. Treasury debt and mortgage-backed securities, which keeps the price up and keeps the interest rates down,” she explained. “If foreigners, for whatever reason, cut back on their purchase of this debt, that would tip the scales unfavorably and cause a recession.”

 The second concern is energy prices. “Since gasoline prices have dipped recently, we tend to forget that they are still substantially higher than they were a year ago. The situation in the Middle East is volatile and anything that happens there to reduce supply would have a negative impact,” she noted.

The third item ties back to housing and the decline of household wealth. “There has been a lot of talk among some analysts that we don’t have to be concerned that the savings rate in our country is actually negative. That has happened only once before in our history - in 1932-1933. But shrinking household wealth is a concern because for many of us – as our home is our single biggest investment and source of wealth – when we have debt on that asset that remains steady while the value of that asset decreases, that is a problem.”

Dr. Adams’ forecast does not include sharp increases in energy, but notes that they will likely remain high. Mortgage debt will increase as many of the adjustable rate mortgages (ARMs) that people got into two or three years ago are adjusting upward now as interest rates have increased. “The only way to handle increasing payments is to cut back on spending in other areas,” Dr. Adams noted. “Because consumers account for 70% of economic activity, all it takes is a small decline in each household’s spending to guarantee a recession. The current situation is unstable; I believe it is unsustainable for another 18 months. So I’m not only give the timing for the recession, I am also attaching probabilities to it: I believe that there is a 75% probability that the U.S. economy will be in recession before the end of 2007 and only a 25% chance that growth will continue – and even if it does continue, it will be at a much slower rate.”

Dr. Adams gives the baseline scenario for the hard landing a 40% probability as growth and output is expected to be at 2.1% next year; housing starts will be down nationally 12%, auto and truck sales will be down, and unemployment will move to around 5%. Inflation next year is expected to average around 3.5% (assuming that there is no spike in energy prices.) Short-term rates will come down in that scenario as the Federal Reserve will try to mute the rise in inflation, but long-term rates will remain high. If foreign investors cutback on spending on U.S. debt, then mortgage rates will rise above 7%. If they continue to purchase debt, which we issue more and more of every month, rates will stay close to their current level. Dr. Adams gives the soft landing a 30% chance and the worst-case scenario a 20% chance.

As for Colorado, Dr. Adams doesn’t see anything that would make us any different than the rest of the country; consumers still have the same degree of financial stress here as they do anywhere else. “However, there is data that shows we have more variable rate mortgages and a higher level of credit card debt in Colorado than most other states,” she noted. “The energy industry is in the middle of a sort of boom, but it is different than the boom we saw back in the 1980s where we had national and international headquarters here. Most activity is concentrated in Weld county and western slope counties. The other thing that might make a difference is the national defense industry as we rank around 12^th or 13^th in the country with defense contracts, primarily concentrated in Colorado Springs.”

Dr. Adams’ forecast for employment growth for Colorado is at 1.4%, with the unemployment rate inching up to 4.8%. With per capita personal income of 3.6% and metro Denver inflation averaging 2.8%, there will be very little real improvement in the standard of living. Retail sales growth will slow from 10% to a little above 2% next year. Housing permits are down 11%, the third consecutive year of decline in Colorado -- which is actually good news, as we don’t have the housing bubble that some areas of the country are experiencing. In a nutshell, the deeper the recession nationally, the deeper the recession in Colorado.