US Economy shrinks

www.bea.gov:

Real gross domestic product -- the output of goods and services produced by labor and property located in the United States -- decreased at an annual rate of 0.1 percent in the fourth quarter of 2012 (that is, from the third quarter to the fourth quarter), according to the "advance" estimate released by the Bureau of Economic Analysis. In the third quarter, real GDP increased 3.1 percent.

Who would've predicted this?

According to data... another US recession is likely to begin between now (2011 Q4) and 2012 Q4

There will be another economic crisis in 2012. It will be bad. These are the economic lessons we should learn from it.

I'm breaking my recent silence not just to reiterate my previous predictions but also (in one of those slightly snarky, arrogant ways) to propose a solution for those in the future who may be reading this.

First of all, consider this graph:

Regular readers (whoever you people are) will recognise this graph as being part of series of posts I have made in 2011 predicting another economic downturn in 2012. This is based upon a study of Real Ten Year Bond Rates (Bonds minus annual inflation) averaged over a three month period. The methodology I use and historical graphs can be found here. Basically the conclusion I came to was this:

While recessions can occur without negative real interest rates, whenever negative real interest rates do occur, they are always followed by an eventual recession.

This conclusion is based upon the fact that every instance of negative real interest rates (which I define here as negative real 10 year bond rates) there is an eventual recession. This occurred in the following periods:

• In March 1957, rates went negative. A recession followed in October 1957. (Rates also went negative during the recession)
  
• In October 1973, rates went negative. A recession followed in January 1974.
• In November 1978, rates went negative. A recession followed in April 1980.
• In January 2008, rates went negative. A recession followed in April 2008.
• In June 2011, rates went negative. I'm therefore predicting a recession to occur in 2012.
  

So that's what I'm predicting. I'm going to modify my superannuation exposure to conservative as a result because I see no reason why this coming recession won't be a big one and lead to another credit crisis and market crash.

Okay. So that's all that. So now let's assume you're reading from the future and the recession I predicted occurred and thus you feel somewhat interested that someone before the recession predicted it and was able to prove it in an empirical manner based upon data. Either that or you're guffawing at me for getting it wrong. However since I have little to lose and a lot to gain by making this prediction I'm obviously going to go ahead and make it.

Well then. You're from the future. You're now looking back at actions that could've prevented the recession. Had the powers-that-be the knowledge that One Salient Oversight has, what would they have done differently? In other words, what steps could've been taken to avoid the 2012 economic downturn? This is basically the reason for this post.

So in order for the downturn to be potentially avoided, there needed to be a watch placed upon negative real bond rates - in the same way as a watch is placed upon an inverted yield curve. So let's say that occurred. What would've happened?

The statistics show, as I have pointed out above, that June 2011 saw the rates go negative. From the graph above we see that in the six months leading up to that event, the following occurred:

• 10 Year Bond Rates hovered around 3.4%, with a high of 3.58% in February 2011 and a low of 3.17% May 2011.
• Annual inflation in that period averaged 2.4%, with annual rates increasing steadily each month from 1.1% in November 2010 to 3.1% in May 2011
  

After that period, from June 2011 onwards, Bond Rates have averaged 2.3%. This has occurred as a result of financial turmoil arising from the Euro crisis. Inflation has averaged 3.5% though.

The Euro crisis started in July 2011. A minor event during that time was also the US government debt ceiling crisis, whereby the market began to get riled by chances of a default (which nevertheless didn't affect US government bond yields).

But the stats show that it was inflation which increased, and this occurred between December 2010 and September 2011. So what was it that caused such an increase in consumer prices? Let's look at oil, courtesy of FRED:

There's no doubt that oil was involved in the inflation, however we don't see any real price hit until March 2011 and inflation began growing in December 2010.

So what was it that caused the inflation of 2011 Q1 and Q2?

It was QE2 - the second round of Quantitative Easing.

QE2 was an unconventional form of monetary policy that the Fed under Ben Bernanke introduced in December 2010. It involved creating money by fiat and using it to buy back government bonds. Its purpose was to increase liquidity and act as a loosening of money supply. It was enacted because the limits of conventional monetary policy had been reached, namely that the Federal Reserve Rate was essentially at zero and could not be lowered further.

Thus QE2 was a defacto lowering of interest rates.

There were fears from many, me partly included, that QE2 would result in uncontrollable inflation. This was certainly not the case as inflation since then hasn't been too high. Nevertheless, these were my own views at the time:

(All) this goes back to whether the money supply should be increased. While US inflation is low (currently 1.14%, year on year) deflation is hardly a problem just yet. Deflation hit the US economy very hard in late 2008 when the credit crisis hit, but since then prices have stabilised somewhat. Paul Krugman and others would argue that the US should actually target 4% inflation as a goal rather than as a limit, in which case Bernanke's policy is heading in the right direction. Interest rates have certainly bottomed out, but where is the deflation that can't be influenced by conventional monetary policy?

And this therefore calls to question the reason for quantitative easing. Is Bernanke aiming to stimulate the US economy or is he simply trying to maintain price stability? If it were the latter, then Bernanke is crazy since the US doesn't have a problem with price stability at the moment (unless you adhere to absolute price stability like I do, of course, but that's another topic!), which means that QE2, as an inflationary policy, is being implemented when prices are not in danger of deflating. This can only mean that Bernanke is aiming to stimulate the US economy, and this is problematic.

To be fair, at that time I was not seeing QE2 and the resulting inflation as a way of creating another recession. That was because my study of real ten year bond rates and their historical relationships to recessions had not yet been realised. I did point out that the Fed's dual mandate was problematic (I believed then, and still do now, that central banks should focus solely upon price stability, while governments should focus upon policies to encourage economic growth. This is an increasingly unfashionable belief in this day and age, though).

As for Quantitative Easing as a policy, I had and still have no real problems with it. In fact I wrote this article at the time in which I propose a more complete form of QE that could potentially replace the use of interest rates in future monetary policy. What I questioned then whether it was needed since prices weren't exactly unstable at the time.

In retrospect, however, it seems that QE2 actively caused the next economic crisis. I didn't know about real ten year bond rates at the time, but now that I do I can see what happened. QE2 pushed inflation up, created negative real ten year bond rates and, as a result, created the trigger for the 2012 downturn.

There's no doubt that many will blame the Eurozone crisis for the 2012 downturn. There's no doubt that it made conditions worse (it probably resulted in a flight to US bonds which, in turn, depressed yields) but the simple fact is that the Eurozone crisis began after rates turned negative. Here is proof:

These are screenshots taken today (2012-02-26) from Bloomberg, showing government bonds in Greece and Italy. The Greek bonds are here. The Italian ones are here.

What these unequivocally shows is that the Euro crisis had begun in July and continued apace as the year progressed. However real 10 year US bonds went negative in June, the month before the crisis began (and remember these are three-month averages). There's obviously going to be arguments as to which was the chicken and which was the egg, but there's no doubt that the problem began in the US before anything bad happened in Europe. In fact I wonder whether we could blame QE2 for the Eurozone crisis too? I'll refrain from that at the moment but I will say that I was never a fan of Europe's lax fiscal attitudes.

There's a number of implications to my argument that QE2 caused the (yet to happen) 2012 downturn.

The first is that price stability is obviously important and that a lid must be kept upon even benign levels of inflation, even in the face of high unemployment and low growth. Because unemployment had gone so high after the 2008 crash, and because GDP had declined so precipitously, the majority view eventually rejected "inflation hawks" like me. The Fed and luminaries like Paul Krugman argued that higher levels of inflation can be sustained because there was so much slack in the economy caused by the GFC. This may have a kernel of truth, but the fact remains that inflation ended up exceeding 10 year bond yields and triggering another downturn. The irony is that policies designed to improve the economy actually ended up making it worse.

The need for price stability even in the aftermath of a damaging recession certainly challenges prevailing views, especially about the nature of inflation. In the logic presented here,  12% bond rates alongside 11% inflation are to be preferred over 2% bond rates alongside 3% inflation. While my own views on inflation are unique and unlikely to be taken seriously by policy makers for some time, what this current situation does show is the need to read more into inflation than merely consumer prices -  namely that market investment decisions may be such that even "acceptable" levels of inflation (eg the 4% touted by the Fed and Krugman) may be too high if the market is ploughing too much of its funds into government bonds. Any policy that would've maintained positive real interest rates either on the inflation side (ie not initiating QE2) or on the investment side (eg substantially increasing bond issues to push rates higher) would've been better than what actually transpired.

A second implication involves the behaviour of the Fed. This is not the first time real bond rates have turned negative. the last time it happened was prior to the GFC. It looks like we've been fooled twice by the Fed on this one:

There we have it. The green line tells the story. August 2007 seems to be the key here: despite being faced with an increase in inflation (the blue line), the Fed refuses to increase the Funds rate. Inflation increases, the bond rate falls and suddenly we have negative real bond rates. A recession then hits in late 2008. The same conditions beset the US during the 1970s, though during that period inflation was far higher - as were bond rates. Twice in a row inflation exceeded bond rates and twice these conditions were followed by recessions. This behaviour was stopped, of course, by Paul Volcker and his inflation busting recession of the early 1980s and created the conditions for what is now disparagingly called "the great moderation". Certainly the recessions of the early 90s and early 2000s weren't prevented by positive real interest rates, which indicates that there are more to recessions than simply this particular trigger. Nevertheless it cannot be written off as mere chance that recessions follow negative real bond rates as clearly and as predictably as the negative yield curve.

So will we be fooled again by the Fed even after the 2012 downturn? Only if the new boss is the same as the old boss I suppose.

(By the way, the governor at the Fed in 2007 who made this decision is the same governor now who made the decision again)

As far as unemployment is concerned, I'm not changing my original prediction:

Unemployment will also likely peak between 12.1% and 18.7%, with a result around 16.9% the most likely.

You can imagine what this will do to US government debt.

I'll just finish by predicting that this downturn is likely to also change our understanding of the inverted yield curve. With the Federal Funds rate at zero there is no way that the yield curve can invert. (Of course we might be tempted to think that recessions have been solved and that we'll all experience a golden age because zero rates prevent an inverted curve, but recessions are unlikely to worry about things like this). Obviously the only thing that will change the Fed's ZIRP would be an outbreak of uncontrollable inflation. While this is still a possibility my belief is that the yield curve will end up simply becoming a straight horizontal line: Government bond rates will approach zero. This implies a huge flight into government securities, which in turn implies a market correction rivaling and maybe even exceeding that experienced in late 2008. Perhaps the 2012 downturn will be a mixture of both credit crisis and inflation.

Now the reason why I'm talking about the yield curve here is that if there is a recession then the yield curve will invert (ie turn into a horizontal line), and we know there will be a recession because real bond rates are negative, so the yield curve will become horizontal. And that's why I'm going to get my superannuation funds and other savings placed into as conservative a position as possible.

I'll just end with this graph for a laugh:

More on EV Batteries

I've been doing some more thinking about Electric Vehicles and the battery technology that will drive it to eventually replace internal combustion cars.

In the previous article I pointed out that Electric Vehicle Battery Packs need to have an energy density of around 675 Watt-hours per kilogram (Wh/kg) if they are to have an equal range to today's petrol-powered cars. I also pointed out that the Nissan Leaf - the world's first truly mass-produced electric car - has a battery pack with an energy density of around 131.57 Wh/kg. This means that the Leaf only has an effective range of approximately 117km (72 miles). "Range Anxiety" is truly a problem for Leaf owners - even though the total cost of charging the Leaf is lower per kilometre than the cost of filling up regular cars with petrol (the equivalent fuel efficiency for the Nissan Leaf is 2.4 litres per 100 km - 99 miles per gallon).

As a result of this study, I've done some more number crunching - this time taking into consideration various different types of vehicle. The Nissan Leaf is essentially a "Compact Car" or "C-Segment" vehicle. The other electric car that is dominating the EV market is the Mitsubishi i-Miev. The i-Miev is different to the Leaf in that it is a "Subcompact" or "B Segment" vehicle (also known as a Kei Car). This means it has a smaller engine (47kw compared to 80kw in the Leaf) and is lighter (1080kg compared to 1521kg). Thus the cars can't really be compared.

So what I did was examine the various different types of cars and work out just how much battery density needs to increase before the range of that particular vehicle class can be effectively equaled by an EV.

The image from my spreadsheet is too large to post here, so click here to see it directly. I obviously need to explain it, so have it open in one tab while looking at this page and flick between them.

Each different column colour represents a vehicle class. We have Subcompact / B Segment all the way up to Full SUV / J Segment. In each of those columns I have also included a base vehicle to use by way of comparison. Since we recently bought a VW Caddy, I decided to stick pretty much with Volkswagens as far as possible, with the notable exception of the Australian Ford Falcon and Range Rover. Each of these vehicles is given a fuel economy figure in Litres per 100km (to convert to mpg, click here). I've also included the size of each fuel tank, in both litres and in weight, as well as in kilowatt hours of storage. The cars I used all had petrol, not diesel, engines.

Column B shows energy storage in Wh/kg. This assumes that, as technology improves, more and more power is able to be stored in an EV battery.

All those numbers from column 9 downwards, and from column D onwards, are the range (in kilometres) of each vehicle class according to the energy storage numbers in column B. The most important cell in this section, and the spreadsheet, is F19, showing 117km range at 131.57 Wh/kg for a compact car. This is the base figure for the Nissan Leaf that I mentioned above and in my previous post.

The important figures are shown there in bold. I'll dot point them here:

• Subcompact (VW Polo): 600 Wh/kg for 600km range.
• Compact (VW Golf): 675 Wh/kg.
• Mid Size (VW Passat): 785 Wh/kg
• Compact SUV (VW Tiguan): 950 Wh/kg
• Full Size (Ford Falcon): 1100 Wh/kg
• Mid SUV (VW Toureag): 1300 Wh/kg
  
• Full SUV (Range Rover): 2800 Wh/kg
  

As you can see, it is obvious that 675 Wh/kg may be enough to completely control the Subcompact and Compact markets, but as soon as you take bigger vehicles into consideration, the energy density needs to be higher. And this shows how the market will react as time goes by: the smaller, lighter vehicles will become more dominated by EVs than the bigger, heavier vehicles.

I've also placed another figure to look at: the energy density needed for the vehicle to have a range of 1000km. This is an important figure (though arbitrary) that will affect EV design. If we assume, for example, that battery energy density reaches 1300 Wh/kg (and thus control the mid sized SUV market), what would happen to the subcompact market? Well according to the spreadsheet, such a vehicle would have a range of 1300km, more than twice what is probably needed. When this occurs, it is very likely that EVs will have less space dedicated to battery packs and more space dedicated to other aspects, such as greater boot space and leg room. Thus the cars will have an ever increasing usability.

This is not outside the realms of possibility. Think about the battery packs needed to power your mobile phone or laptop - they have been decreasing in size and increasing in energy intensity for some time. The same should be true for EV battery packs.

Now the second part of the graph needs some explanation. It is essentially the application of Moore's Law to battery technology in column B (column C is the multiplier for the spreadsheet, so ignore that unless you wish to check my figures - which you are welcome to). Moore's Law, in this case, assumes that battery energy density will double every two years. If we take this year (2011) to be the year when battery packs of 131.57 Wh/kg are currently available to the market (ie the battery packs for the Nissan Leaf), then you can see the sort of battery energy density that could be theoretically available as years go by.

If we take...

• a range of 300km to be the sort the market will respond to positively (and thus begin to be competitive with petrol driven vehicles),
  
• and if we see a range of 600km to be the sort that will completely control the market (and make petrol driven vehicles obsolete),
  
• and a range of 1000km to be the point at which these vehicles begin to reduce the amount of space needed for battery packs (and thus increase usability by having more space),
  
• and if we apply Moore's Law to battery technology...

...then we will see the following:

• Subcompact EVs will begin to be used in number from 2014. They will begin to control the market in 2016. They will begin to increase usability from 2017 onwards.
• Compact EVs will begin to be used in number from 2014. They will begin to control the market in 2016. They will begin to increase usability from 2018 onwards.
• Mid-Size EVs will begin to be used in number from 2015. They will begin to control the market in 2016/2017. They will begin to increase usability from 2018 onwards.
• Compact SUEVs will begin to be used in number from 2015. They will begin to control the market in 2017. They will begin to increase usability from 2019 onwards.
• Full Size EVs will begin to be used in number from 2015. They will begin to control the market in 2017. They will begin to increase usability from 2019 onwards.
• Mid-Size SUEVs will begin to be used in number from 2016. They will begin to control the market in 2018. They will begin to increase usability from 2020 onwards.
• Full-Size SUEVs will begin to be used in number from 2018. They will begin to control the market in 2020. They will begin to increase usability from 2022 onwards.
  

Now I don't really know too much about how the car market reacts to new vehicles and how long it takes for them to be taken up by the market, but it is probably likely that 2014-2016 will be the years when the electric car begins to hit world markets in number.

Another recession? I told you so.

There have been some very severe financial fluctuations in the past 24 hours. I won't even bother linking to any news or financial sites because you know it already. Here in Australia a number of very respected people are saying that this is the beginning of another financial crisis that will inevitably lead to another recession.

At the risk of sounding unbearably smug I have been predicting such an event. To be honest, though, I didn't expect the sudden crunch happening now. Moreover I wasn't basing my prediction upon "gut feeling" but upon data.

It all started back on 2011-06-17 when I wrote a post entitled A Recession indicator has been triggered . This was not just an important predictive event but also an important step in my own understanding. The fact is that for some months now I have been publishing a series of posts called "Recession Indicators". What happened was that my own study of real interest rates seemed to prove conclusively that whenever real 10 year bond rates (10 year bond rates minus inflation) went negative, a recession was inevitable. This is what I said:

What I discovered from this analysis is that while recessions can occur without negative real interest rates, whenever negative real interest rates do occur, they are always followed by an eventual recession. This occurred in 1957, 1974, 1980 and 2008.

So what about the present? Last week US inflation for May 2011 came in at 3.4438% while Ten Year Bond Rates for that month were 3.17%, which meant that real interest rates dropped to -0.2738%... if the June result continues to be negative, and if this continues into July, then the chances are that a recession will be sooner rather than later.

Then on 2011-06-24 I published the June 2011 recession indicators where I said

According to data from negative Real Interest Rates, another US recession is likely to occur between 2012-Q1 to 2014-Q1, with 2012-Q4 being the most likely.

Then on 2011-06-29 I published another post entitled Real Interest Rates are predicting an upcoming recession. Between this post and the previous one I had refined my study of real 10 year bond rates - averaging them out over a 3 month period in order to iron out a statistical "bump" in the data (which turned out to be Hurricane Katrina). By comparing these results to GDP and unemployment data, I came up with the following  assertions:

• Once (real 10 year bond rates) turn negative, a recession occurs, on average, 8½ months later.
• The median is 6 months.
• Results vary between 4 months and 18 months.
• The highest unemployment rate during the recession is, on average, 1.8 times the unemployment rate of the month when real interest rates turn negative.
• The lowest increase is 1.32 times; the highest increase is 2.03 times.

Now the thing about this particular post is that the 3 month average had yet to turn negative, so I prefaced my pronouncement with the caveat that "if" rates went negative the following month, then:

A recession starting between 2011 Q4 and 2012 Q4, with 2012 Q1 (is) most likely.

Then on 2011-06-30 I wrote a lengthy piece about what was likely to occur between now and the recession entitled The events leading up to the coming downturn. The idea was that, because I had two other recession indicators that unerringly predicted past recessions in hindsight, then any potential recession coming up would also have to influence these indicators. I decided that there were going to be two possible situations occurring, an inflationary outcome or a deflationary outcome:

An inflationary outcome would result in inflation outstripping the new monetary base. This would mean that, in the time leading up to the recession, inflation would increase...

The deflationary outcome, like the inflationary one, won't have to be sudden or substantial to presage the recession. If inflation sits at 1% and the Net Monetary Base grows at 0.5% - both near zero but slightly inflationary - the result will still be a negative spread and an upcoming recession. A decrease in the price of oil and an increase in the value of the US Dollar (the USDX) is likely to accompany this deflationary outcome.

The deflationary outcome would mean that the Federal Funds Rate remain low while the 10 Year Bond Rate crashes down to similar levels. This, in turn, would mean that the Bond Rate would be 0.09% or below. This, of course, would indicate massive financial distress that would be accompanied by a sharemarket crash of epic proportions and a credit crunch that would make 2008 look like a picnic.

When I balanced the two out, I decided that the inflationary outcome was more likely. After yesterday's crashing market, there is a much higher likelihood of a deflationary one. To be honest, the thought of the 10 year bond rate dropping below 0.1% is quite frightening.

So they were my June predictions. What about July? On 2011-07-07, when 10 year bond data came out, I wrote an article titled The chance of avoiding another downturn is now almost impossible.

After having my views changed on austerity (namely that the economy was no longer able to produce jobs in a recovery), on 2011-07-09 I outlined "OSO's New Deal" in which I argued that the US Government needs to spend more and tax more in order to a) boost economic growth, and b) generate more revenue to pay off its already considerable debt. While this was not a predictor of events to come, it did outline what I thought (and still think) is the answer to our current economic woes.

On 2011-07-20 I published the next recession indicator series. I made the following points:

If we take previous instances of negative real bond rates into account, a recession will start between 2011 Q4 and 2012 Q4, with 2012 Q1 the most likely. These previous experiences also indicate that unemployment will also likely peak between 12.1% and 18.7%, with a result around 16.9% the most likely.

Since then my blogging was mainly concerned with the US debt ceiling crisis. Since the resolution of this crisis, the markets have teetered and fallen. While I would no doubt agree that the debt crisis spooked the markets, I would argue, based upon the data and conclusions that I have been publishing since June, that a recession / downturn was always going to happen at some point. It seems like the debt ceiling crisis was the trigger for it happening sooner rather than later.

Now of course I need to add the disclaimer. We're not in another recession just yet - it is still too early to tell whether we are, at present, suffering another downturn. Moreover there is nothing to suggest that the current crisis in financial markets is going to continue like it was 2008. Markets just might do that, but then again they might not. I'm not going to predict how the markets are going to respond over the coming days weeks and months. Nevertheless I do think that there is enough evidence to show that another market downturn and another recession are going to happen within the next 18 months, and I will stick by that.

US Downturn for 2012 now assured

The Real 10 year bond rate average over 3 months has now dropped below zero to -0.12%. As I have been pointing out for the last month, this presages another economic downturn for the United States.

Inflation just came in at 3.4%. Even though June saw a monthly deflation, it wasn't enough to prevent a move into negative real bond rates.

The monthly Real 10 year bond rate also had its second month in negative territory at -0.43%.

The chance of avoiding another downturn is now almost impossible

10 Year bond rates for June 2011 came in at 3.00%. Inflation figures for the same month are due on 2011-07-15 (Friday next week).

In order for the US Real 10 year bond rate to remain positive, June inflation needs to have an index reading of 223.496 - which implies a monthly deflationary result of -0.6%. At this point there is very little evidence of a deflationary hit in June (eg soaring US dollar, credit crunch, large drop in sharemarket value).

Take a look at my spreadsheet.



June's potential recession avoiding index result of 223.496 is shown there in green. Any inflation index result of 223.497 or higher will result in column N (real 10 year bond rates averaged over three months) moving into negative. This presages a recession. When the inflation data comes out Friday next week, a coming downturn will be confirmed.

For those of you who are spreadsheet minded, here are the details:

• Column C data from here.
• Column D equation (at 701) is =PRODUCT(((C701-C700)/C700)*100).
• Column E equation (at 701) is =PRODUCT(D701*12).
• Column F equation (at 701) is =PRODUCT(((C701-C689)/C689)*100). (This is the "headline inflation" result).
  
• Column I data from here.
• Column J equation (at 701) is =SUM(I701-F701).
• Column N equation (at 701) is =AVERAGE(J699:J701).

The events leading up to the coming downturn

Further to my thinking from last post, I began to consider the two other recession indicators I have discovered - obviously they will both turn negative in time for the next downturn. This means there is a possibility that we can predict what may occur.

In short we have two potential outcomes leading up to the downturn: an inflationary one or a deflationary one.

Net Monetary Base vs Inflation (spread)

This measures the growth of the net monetary base (M0 minus excess reserves) over inflation. My original study is here. If we assume that a recession is due, what will happen to this indicator as it approaches? For the spread to turn negative, inflation must exceed the growth of the net monetary base. This can happen one of three ways: An increase in inflation; a decrease in the Net Monetary Base; a combination of the two.

An inflationary outcome would result in inflation outstripping the new monetary base. This would mean that, in the time leading up to the recession, inflation would increase. If the Fed does not instigate any Quantitative Easing, the chances are that this increase in inflation won't necessarily be big. Although a Latin America style inflation increase is possible, it's probably likely for inflation to get close to 10% and not much more before the recession hits. The only reason I use for this is that, historically, the US hasn't experienced a hyper-inflationary hit.

We need to also understand that the Fed has probably pushed the inflation limit to around 6%. I remember Krugman talking about this and the Fed's reluctance to increase the Federal Funds rate (currently 0.09%) in the face of growing inflation (now 3.4% - the last time inflation increased to around this level in October 2007, the Federal Funds rate was 4.76%) speaks for itself. So we're probably looking at inflation increasing to beyond 6% and up to around 8% before the Fed begins to push rates up again. By that stage inflation would have increased beyond the growth of the Net Monetary Base.

An increase in the price or oil and/or a decrease in the value of the US Dollar (the USDX) is likely to accompany this inflationary growth.

For a deflationary outcome, this would mean that the Net Monetary Base would be shrinking faster than the inflation rate - which would remain benign or turn into deflation. Only once in postwar history has the Net Monetary Base declined: in December 2000 and January 2001, a decline which presaged a recession later in the year.

The deflationary outcome, like the inflationary one, won't have to be sudden or substantial to presage the recession. If inflation sits at 1% and the Net Monetary Base grows as 0.5% - both near zero but slightly inflationary - the result will still be a negative spread and an upcoming recession.

A decrease in the price of oil and an increase in the value of the US Dollar (the USDX) is likely to accompany this deflationary outcome.

The May 2011 result for this indicator was 540, still in positive territory. As the recession approaches this number will drop quite substantially. Moreover, considering the time it will take for this result to drop, a 2011 Q3 recession start date (next quarter) is highly unlikely.

Federal Funds Rate vs 10 Year Bond Rate (spread)

This measure the difference between the 10 year bond rate (GS10) and the Federal Funds Rate (FEDFUNDS). When the 10 Year bond rate drops below the Federal Funds Rate, the data indicates that a recession will follow.

The 10 Year Bond rate is, according to my stock ticker, 3.11%. The Federal Funds Rate is currently 0.09%. In order for this spread to turn negative, the Federal Funds Rate must increase, or the 10 Year Bond Rate must decrease, or a combination of the two must occur.

The only way the Federal Funds Rate will be increased is when the Fed decides that the problem of inflation is greater than the problem of high unemployment and low economic growth. As I stated above this thinking seems to hover around the 6% inflation level, so chances are that the Fed will begin to raise the Federal Funds rate once inflation begins to increase beyond 6%. As these rates go up in response to more inflation, it will inevitably exceed the 10 Year Bond Rate, thus presaging the downturn. This is the inflationary outcome.

The deflationary outcome would mean that the Federal Funds Rate remain low while the 10 Year Bond Rate crashes down to similar levels. This, in turn, would mean that the Bond Rate would be 0.09% or below. This, of course, would indicate massive financial distress that would be accompanied by a sharemarket crash of epic proportions and a credit crunch that would make 2008 look like a picnic. A soaring US Dollar is likely to accompany such a crunch (as it did in 2008).

So what will happen?

The most likely scenario in my mind is one in which inflation increases beyond 6%, forcing the Fed to increase the Federal Funds Rate. This growth in inflation will exceed any increase in the Net Monetary Base. The increase in the Federal Funds Rate will also allow the spread between it and the 10 Year Bond Rate to narrow and eventually turn negative.

The reason why this is the most likely scenario is that inflation is already increasing, and the Fed has chosen a deliberately inflationary policy (Quantitative Easing). Peak Oil ensures that oil supplies will be harder to maintain, thus forcing an increase in oil prices and thus inflation.

So when will this happen?

As I have pointed out in my last prognosis, the next downturn will begin any time between 2011 Q4 and 2012 Q4. In the 6-18 months prior to this, we will see inflation increasing beyond 6%.

It's important to keep an eye on the recession indicators over the coming months. Watch as the Net Monetary Base / Inflation spread begins to drop towards zero. As inflation increases keep an eye on Fed announcements on monetary tightening, with the knowledge that an increase in the Federal Funds Rate will inevitably lead to a negative spread between the funds rate and the 10 Year Bond Rate.

Can the downturn be avoided?

No. I'm fairly certain that it will happen within the timeframe that I predict. The only thing that would save us is a return to positive real interest rates in June, a result that would imply an increase in bond rates and/or deflation.

What would OSO do if he were Ben Bernanke, armed with this knowledge?

Raise interest rates / tighten monetary policy. Get the recession over and done with. Set a tighter inflation target (preferably "zeroflation"), rather than a looser one.

What will we learn from this experience?

The 2008 crisis caused a rethink in inflation expectations - specifically whether current inflation targets weren't working. I agreed with this rethink but suggested that future policy be aimed at what Krugman calls "Hard Money". My argument was and still is that prices need to remain constant, neither inflating nor deflating over the long run, and that the best way to measure success at this level is to have the GDP deflator at zero over the long term. Unfortunately current thinking is that inflation targets need to be looser rather than stricter (eg Krugman, Stiglitz). I believe that these loose policies have created the conditions for negative real interest rates which will now doom the US economy to another downturn. Had "Hard Money" policy been enacted (by which inflation was controlled), there is no doubt that the current recovery would be slower but at least it would be sustainable. As it is, the loose money policy will simply create another bust and make things even worse.

I've also believed that national debt needs to be paid off rather than inflated away or defaulted. Using the policies we already have at hand I have suggested that the best way to turn around government finances is to raise taxes on the rich rather than cut spending. Taxing an overinvested share market through a Tobin Tax or a market capitalisation tax would serve to both punish financial bubble formation and create revenue to pay back debt. As for new policy, I would suggest someone seriously implement part of my zero tax economic system and simply pay off debt through money printing (what is now known as Quantitative Easing) while increasing the reserve ratio to prevent any resulting inflation. And as for reducing unemployment... set up a universal employment subsidy that makes it cheaper for firms to employ people while simultaneously raising wages - all at the expense of higher taxes (or more QE).

Using the Monetary Base as a Recessionary Indicator

"The reason why there is inflation is because the money supply is increasing"

I've heard that argument so many times over the years I decided to look at the data. So I began keying in the increase in money supply using the AMBNS data series at the St Louis Fed when I saw this problem:

Yep, the monetary base seems to have gone into overdrive since the Global Financial Crisis hit. The problem was, though, that in a credit crisis banks and financial institutions tend to sit on their money. I then discovered the EXCRESNS data series at the St Louis Fed, which measures excess reserves:

Yes well that graph is certainly frightening and pretty much confirms that the financial crisis we are experiencing is the worst since the great depression. Yet despite the fact that the Fed has been madly pumping money into the economy and increasing the monetary base (M0), "depository institutions" (ie banks, mainly) have sat on a lot of that money. In other words, a lot of the increase in money supply has been countered by a resistance to lend. Yet there is obviously a way to more accurately measure the net amount of money in the monetary base by removing the excess reserves from the monetary base figure. So to come up with the "Net Monetary Base", we get the M0 figure ("AMBNS") and take away the excess reserve figure ("EXCRESNS"). So I punched up the data into my spreadsheet and this is what I have come up with for the past 20 years:

Well there we have it. A line going up. Woo hoo OSO you've done some great work there.

But it's not the actual amount of money we're interested in so much as the annual increase. So here's the year on year increase in Net M0, with recession bars thrown in:

Now THAT looks more interesting doesn't it? In fact the most obvious question I had when I first made this graph was "What is that spike in the money supply in the middle of the graph?" According to the Federal Reserve Bank of New York:

A variety of factors continue to complicate the relationship between money supply growth and U.S. macroeconomic performance. For example, the amount of currency in circulation rose rapidly in late 1999, as fears of Y2K-related problems led people to build up their holdings of the most liquid form of money...

Interesting stuff. Yet there also seems to be another factor at play here, namely the fact that recessions seem to be associated with monetary bases that are only growing slowly. Let's look at the same graph for 1970-1990:

Oh well so much for that theory I suppose. Look those four recessions in the 1970s and early 1980s - obviously the money supply was increasing before and after these recessions. If we connect the above graph with the 1990-2010 one we'll even see that while the increase in the money supply drops in the late 1980s, it is still increasing when the early 1990s recession hits. So it appears as though the experience of a contracting money supply causing a recession is only applicable to the last two recessions. Or is it?

We need to remember that inflation is something which needs to be factored in here. While inflation can be caused by an increase in the monetary base, it can also result from an increase in money velocity as well as supply constraints. In theory, if the money supply is increasing (or decreasing) at a faster rate than inflation (or deflation), then it means that goods and services are getting "cheaper" in relation to the total money supply; conversely, if the money supply is increasing (or decreasing) at a slower rate than inflation (or deflation), then it means that goods and services are getting more "expensive" in relation to the total money supply.

So let's put that in some graphs - the spread between annual growth in the net money supply and annual inflation, for 1960-1970, 1970-1990 and 1990-2010:

Bingo! Suddenly it all makes sense. Recessions occur whenever the spread between the Net Monetary Base and Inflation is negative. A negative result implies that inflation is greater than the increase in the money supply, which means that a real deterioration in purchasing power occurs. It is thus a reliable recessionary indicator going back to at least 1960.

Of course one of the characteristics of this indicator is that while negative results imply a recession, the actual recession may or may not be directly associated with that period:

• The 1973-74 recession starts almost immediately the spread goes negative (it was the direct result of the 1973 oil crisis, which was a supply shock).
• By contrast, the 1980 and 1982 recessions start after a long negative spread period.
  
• The early 90s recession is also different in that it started after the spread returns to positive.
  
• The GFC recession started after multiple dips into negative territory and continued for some time even when the positive spread exceeded 1000 basis points.
  

Obviously if we keep a close eye on this spread, we can determine whether the economy is in danger of recession. At the present time (using data from November 2010), the spread is 426.61, which is healthily in positive territory. In fact, here's a graph of the last 36 months:

This shows that it was touch and go in the first half of 2010 as the spread neared zero but remained positive, but that things have improved somewhat since then.

To create this graph yourself you can download the following data from the St Louis Fed and use it in a spreadsheet:

• AMBNS (The Monetary Base)
• EXCRESNS (Excess Reserves)
• CPIAUCSL (Inflation Index)
• NBER recession cycles
  

The equation is simple:

1. AMBNS minus EXCRESNS = Net Monetary Base
2. Place the results of the Net Monetary Base and CPIAUCSL side by side in the spreadsheet
3. Use the spreadsheet to determine the year on year percentage growth of both the Net Monetary Base and CPIAUCSL
4. Take the year on year result for the Net Monetary Base and minus the year on year inflation result to discover the spread
5. Add recession bars from NBER data
   

Here is how the page in my spreadsheet looks with this data.

Update: 2011-01-08
Graphs showing each decade can be found here.

Iceland vs Ireland: Which is worse?

Much has been said recently about the contrasting fortunes of Ireland and Iceland. In 2008, both nations were seriously affected by the global financial crisis with both economies declining substantially. Recent commentators, most notably Paul Krugman, have argued that Iceland's response to the crisis has had a better outcome than Ireland's. Iceland, with its own currency, allowed the Krona to depreciate substantially - a process which caused an inflationary bout. Ireland, on the other hand, is part of the Eurozone and while capital flight has been felt in the Irish bond market, the Irish economy has not undergone a currency depreciation - a process which has caused a bout of deflation.

So in order to discover which nation has had a worse economic experience, I have mined some data at official sites. For Irish GDP data, I downloaded the latest Quarterly National Accounts; for Icelandic GDP, I looked up data at Statistics Iceland. In order to ensure harmony between the two datasets (and thus ensure apples are being compared to apples) I cross checked the data with the latest Eurostat GDP release. Then, via a spreadsheet, I have created an Index comparing the economies of the two nations. Here is that index:

As you can see the current situation is hardly good for either nation. According to this index, Ireland's economy has shrunk by 13.4% since 2007 Q4, while Iceland's has shrunk by 11.7%. The advantage that Iceland has over Ireland in terms of GDP is quite small. Moreover, Ireland's economy has been in trouble longer than Iceland's - it wasn't until 2008 Q4 that Iceland's troubles really began while Ireland's had begun 12 months previously.

Nevertheless, one important indicator shows a huge difference between the two: unemployment. The latest figures from The Economist show that Ireland's unemployment is currently 13.6%, while Iceland's unemployment is 7.5%. Another important indicator is the budget balance. The Economist tells us that Ireland's budget balance is -37% of GDP, while Iceland's is only -7.7%. While both nations have serious problems, these figures seem to show that Ireland's is far worse.

Of course one of the reasons why Iceland and Ireland are so different in their experience of the economic crisis is the one that Krugman likes to champion: devaluation. Iceland has allowed the Krona to devalue while the Irish are "stuck" with the Euro. Yet this argument assumes that exchange rate variations don't really matter - at least over the medium to long term. It is obvious, though, that Iceland's GDP has reduced in value in comparison to the Eurozone simply because of the Krona's devaluation. When we factor in the devaluation of the Krona when comparing the two nations, the difference is much starker:

The data for the Krona's performance against the Euro can be found here. I averaged out the monthly mid-range figures for each quarter. For example the Euro-Krona exchange rate for 2007 Q4 was 88.7466926667 while for 2008 Q1 it was 101.325026. I then assigned an index of 100 for the 2007 Q4 and used the math in the spreadsheet to multiply each quarter's decline in currency to the GDP figures.

According to this graph, Iceland's GDP, as measured in Euro, has declined by a whopping 52.1% since 2007 Q4, which is due to a combination of economic decline and currency devaluation. While Iceland's unemployment rate may be lower than Ireland's, holders of the Krona (ie the citizens, businesses and government of Iceland) have had their wealth taken away... not by taxes, not by spending cuts, not by austerity measures, but by the foreign exchange market.

Ireland has a number of choices, none of them good. One choice is to default on debt. Another choice is to take money away from households and businesses in the form of spending cuts and/or tax increases. Iceland, by contrast, has had these choices forced upon them by the currency devaluation. If Ireland had the choice of default, Iceland has already done this as international creditors have lost out on their investment. If Ireland has the choice to take money away from households and businesses, Iceland has already had this done as the purchasing power of the Krona has been essentially halved.

The Iceland/Ireland battle is an interesting one because it lines up different views of economics: Iceland is favoured by Krugman and those who believe in using inflation as a means to reduce real debt; Ireland is favoured by Europhiles and those who believe that currency devaluations and inflation damage economies; Iceland is favoured by those who are not too concerned about sovereign debt default; Ireland is favoured by those who believe that debt should be paid back, especially sovereign debt; Iceland is favoured by those who believe that the Eurozone and its "one size fits all" monetary policy is doomed to failure; Ireland is favoured by those who see inherent advantages in having a common currency and monetary policy which ensures that the currency retains its value; Iceland is favoured by those who believe that monetary policy should be used by central banks to help grow the economy when needed; Ireland is favoured by those who believe that price stability should be a central bank's sole concern, and that fiscal policy should be used by governments to grow the economy when needed.

My bet, of course, is with Ireland - the Eurozone recovery, led by Germany, will create a demand for Irish goods and services, grow the Irish economy and reduce Irish unemployment. Nevertheless it will be fascinating to see how these two nations perform as years go by.

GDP predictions for Q3 2010

Based upon my study of Real Interest Rates over the past three months (government bond rates minus inflation), I am making a judicious prediction of a number of countries.

Note: GDP measured here is change from the previous quarter in annualised form

Economies that were growing in Q2 and will grow faster in Q3

• Australia: > + 4.9%
• Canada: > +2.0%
• China: Growth (quarterly GDP figures not readily available)
• Euro Zone: > +3.9%
• France: > +2.8%
• Germany: > +9.0%
• Japan: > +1.5%
• South Korea: > +5.2%

Economies that are growing in Q3 at around the same rate as they were in Q2

• Argentina: +12.3% steady
• Britain: +4.7% steady
• Italy: +1.8% steady
• Mexico: +13.5% steady
• New Zealand: 1.5% steady
• Russia: Steady (quarterly GDP figures not readily available)
• Spain: +0.7% steady
• Sweden: +8.0% steady

Economies that were growing in Q2 but will begin to slow down in Q3

• Brazil: < 5.1%
• India: Less growth (quarterly GDP figures not readily available)Poland: Less Growth (quarterly GDP figures not readily available)
• Switzerland: < +3.5%
• Turkey: Less Growth (quarterly GDP figures not readily available)
• USA: < +1.7%

Economies that were contracting in Q2 but will perform better in Q3

• Ireland: > -4.8%

Economies that were contracting in Q2 and will be even worse in Q3

• Greece: < -6.8%
• Iceland: < -11.8%

If these predictions are correct then what we will experience in Q3 will be a broad and strong international recovery, especially in the Euro Zone, while the US grows only slowly.

A mild contraction under way?

This is an interesting chart. It is 10-year bond rates since 2008:

For whatever reason I decided to look at this chart as though the US economy was a submarine that hit a seamount, specifically the USS San Francisco incident in 2005 when the nuclear powered sub ploughed straight into the side of an undersea mountain (see this pic). For a while it was touch and go but the crew eventually survived the ordeal.

From looking at these bond rates we see very, very clearly the Q4 2008 financial distress. Bond rates plummeted as investors fled from shares to secure investments. GDP in that quarter plunged by -1.7%, or -7.0% in annualized terms, the worst quarter since Q2 1980. It was a huge financial and economic hit. Remember Lehman/WAMU/AIG? Q4 was quarter which immediately followed those collapses.

By July 2009, however, bond rates had returned to around 4%, and have hovered there since about March-April 2010. Since April, though, rates have begun sinking again.

These rates are dropping slowly, which means that the US economy is probably not going to hit another financial seamount, but will experience, at the very best, very little change in GDP. My opinion is that a contraction is under way and that GDP Q3 and/or Q4 will be mildly negative.

A major indicator will be August CPI figures. If there is a month-on-month decline in the price index, the chances of an economic contraction increase. Prices declined in April, May and June and only an increase in July prevented a four in a row reading (which has not been experienced since 1954). Weekly jobless figures are increasing too, indicating a slowdown.

2010 Q2 GDP

Update 14.20 UTC / 10.20 EST

Markets are down but not drastically. Enough of my hyperbolic ranting. I'm going to bed; it's 20 past midnight here in Australia.


-----------------------------------------------
Update 13.46 UTC / 09.46 EST

What are the odds of the DJIA dropping below 10,000 today? That would be a 4%+ drop. Let's see how bad the markets get over the next 30 minutes.

-----------------------------------------------
Update 13.37 UTC / 09.37 EST

• Wilshire 5000 is down 1.21% after 6 minutes of trading. Ouch.

-----------------------------------------------
Update 13.22 UTC / 09.22 EST

• Bloomberg: U.S. Economy Grew 2.4% in Second Quarter, Below Forecast.
• Oil prices dropped from $77.80 per barrel at 12.30 UTC / 08.30 EST to $77.00 per barrel by 13.00 UTC / 09.00 EST. That's a one percent drop in a 30 minute period. Ouch.
• Bond rates (10 year notes) have dropped since the release too. This means investors are bearish towards the share market. I think we'll see a bit of a drop on today's share market.
  

-----------------------------------------------
Update 13.13 UTC / 09.13 UTC

• The Main driver of Q2 2010 GDP appears to be Gross private domestic investment (pg 23 of 37). The increase is about 25% annualized.

-----------------------------------------------
Update 13.04 UTC / 09.04 EST

• Big increase in government spending obviously helped. 4.4% more than Q2 2009 (pg 11 of 37)
• Federal Government increase was 9.2% more. (pg 11 of 37)
• State and Local Government spending increased only a small amount, but this was after a series of decreases in previous quarters. (pg 11 of 37)
• Big Jump in Imports during Q2 - 28.8%. Exports decreased slightly - 10.3% (pg 11 of 37)

-----------------------------------------------
Update 12.55 UTC / 08:55 EST

• Big jump in personal savings rate, from 5.5% of disposable personal income last quarter to 6.2% this quarter (pg 28 of 37).
• Drop in Motor Vehicle sales was -0.5% less than the previous quarter (pg 36 of 37)
• Big increase in building structures I think, +14.4% more than the proceeding period and the first increase since Q2 2007
  

-----------------------------------------------
Update 12.46 UTC / 08:46 EST

Official Advance Result

• 0.6% ¼ to ¼
• 2.4% annualized
• 2.8% annual

Download BEA release here.

This is lower than the Bloomberg Median but obviously higher than mine.

-----------------------------------------------
Update 12:40 UTC / 08:40 EST


Trying to fix the numbers here to make sense of it all. I'll comment soon.


-----------------------------------------------
Update 12:00 UTC / 08:00 EST

Bloomberg survey results:

Bloomberg Low Forecast

• +0.3% ¼ to ¼
• +1.0% annualized
• +2.3% annual

Bloomberg Median Forecast

• +0.7% ¼ to ¼
• +2.6% annualized
• +2.7% annual

Bloomberg High Forecast

• 1.0% ¼ to ¼
• 4.0% annualized
• 3.1% annual

-----------------------------------------------
The time is 10:35 UTC. The US GDP advance figures will be released at 12.35 UTC. I am expecting GDP to rise but only quite slowly.

The upper limit will be the following:

• +0.2% ¼ to ¼
• +0.6% ¼ annualized
• +2.2% annual

The lower limit will be the following:

• +0.0% ¼ to ¼
  
• +0.2% annualized
• +2.1% annual

I will live blog the release. Let's see what happens.

US Dollar history since 1999 and some predictions

This is a graph of the US Dollar Index since 1999.

Annoyingly, the St Louis Fed "FRED" online tool does not have a USDX graph to check, so I had to add in all the different currency values onto a spreadsheet and then apply all the various weightings. This graph begins in 1999 because the Euro was not around before then and, while I'm sure there are equations and whatnot to cover this change, I haven't found them yet!

But as you can see the US Dollar reached its peak at around the same time as the dotcom boom went bust in 2000-2001. It fell steadily to around 2005, when it regained value somewhat and then fell further until early 2008. Of course the steep rise in mid-late 2008 was due to the effects of the credit crunch and a small plateau of sorts developed before further devaluation began and lasted until November 2009, when it began to rise again. The figure for May 2010 was 85.33.

One of the predictions I made for 2009 was a devaluation of the currency to below 60 on the US Dollar Index. Of course this didn't happen but I'm reasonably confident that it will devalue below 60 at some point. The long term trend is downwards, with a high  of 118.98 in February 2002 and a low of 72.11 in April 2008 seeing a maximum decline of approximately 40% (though in May 2010 the decline from February 2002 was around 28%).

At the moment, consumer prices in the US have declined for two months and the effect of the Obama stimulus plan has begun to wear off, which means that we are heading for a more muted economic performance. I think GDP in Q2 2010 will be very low and I am expecting at least one quarter of negative growth this year. At best we'll see some further deflation and at worst a second credit crunch to rival Q4 2008, which means that investors are probably going to push the Dollar up again as they run away from stocks - a process which has already begun if you look at the far right hand side of the graph.

The only fly in this predictive ointment is European GDP growth in Q2 2010. I believe that EU growth will be higher than US growth during this period and investors will be surprised by European economic strength - to the point where yields on PIIGS bonds will drop. How long this will last I don't know, but monetary conditions in Europe in the last three months have certainly been very strongly inflationary (Switzerland will head them all, whilst Greece will be reasonably poor) whereas monetary conditions in the US have more or less been neutral (and tending deflationary).

Some predictions using real interest rates

My study of real interest rates has been continuing, though without any publishing on this blog due to data collection. There are some predictions though which I have decided to publish today.

I've broken up nations into four groups.

Group 1 - Plunging real interest rates. These are nations whose monetary conditions have dramatically changed over the previous six weeks to promote inflation. These nations are:

• Britain
• Argentina
• Brazil
• Iceland
• Switzerland
• Mexico
• China
• Russia
• Turkey
  

Now of these nations, the one with the lowest CPI is Switzerland, which means that the inflationary growth will not be as serious, while Turkey and Argentina already have high levels of inflation. High inflation levels are bad for an economy because they act to distort prices which, in turn, leads to more inaccurate "money direction" - the choices money holders have in spending or saving or investing or borrowing currency. This inevitably leads to a "peak" in growth, followed by a trough - inflation usually precedes a deflationary economic downturn.

Group 2 - Real Interest rates dropping moderately. These are nations whose monetary conditions have favoured economic growth over the previous six weeks.

• Japan
• Canada
• Euro Area
• Australia
• Ireland
• Spain
• Germany
• France
• Italy
• Sweden
• India
• New Zealand
  

While inflation may result from these monetary conditions such an increase is not likely to be serious. While these conditions do not guarantee economic growth they do act to either improve growth already occurring or to limit any contraction. Of these nations, Ireland is the only one with a contracting economy experiencing deflation, so it is likely that Ireland will experience only moderate contraction and more stable prices in the coming months. Conditions in the Euro Area are improving, which should affect the PIIGS in a positive way. While India's real interest rates have improved moderately, very high inflation continues to afflict them and there is evidence from my data to suggest that India is likely to have some form of economic contraction (ie either a downturn or lower growth rates) soon. Of the nations on this list, Japan and Germany, with price changes close to zero, are more likely to experience sustained growth.

Group 3 - Real interest rates increasing moderately. These are nations whose monetary conditions have favoured economic contraction over the previous six weeks.

• United States
• South Korea
• Poland
  

Again this is not a prediction of economic decline but a contractionary effect upon growth/decline already being experienced. I have collected more data on US CPI and interest rates than any other nation and the data suggests that conditions in the US are not improving. Growth in GDP for Q1 2010 was 3.2%, following on from 5.6% in Q4 2009, which shows that the Obama stimulus of 2009 has passed its peak and is headed on its way down. Real interest rates in the US declined considerably between July and December 2009. In fact "considerably" is too conservative a word to use - real interest rates declined from 5.7% to 0.62% over that six month period. The US would be in "Group 1" in December last year, which indicates that the US economy is beginning to slow down. Considering the speed of the decline and the growth experienced in Q4 2009 and Q1 2010, I would be very surprised if growth ended up exceeding 1.0% for Q2 2010 (which is now).

Group 4 - Real interest rates increasing substantially. These are nations whose monetary conditions have seriously deteriorated over the previous six weeks.

• Greece

Greece has suffered mainly from the market's fear of a sovereign debt crisis - and such a fear is not unfounded. With increasing austerity measures being put into place, Greece's economy looks set to contract - ie shrink - some time this year. Inflation in Greece is still running a little high (3.9%) but increases in bond rates have more than exceeded this amount. Inflation in Greece is likely to turn into deflation as soon as the economy begins to shrink. Growth in the Euro Area, though, is likely to moderate any Greek downturn (and also help Ireland stop its current economic decline).

And that's Stephan Bibrowski in the picture.

US Unemployment

Today is yet another doomsday - the December 2008 unemployment figures are due and the expectation is something bad.

November 2008 rate was 6.7%.

I predicted that US unemployment would reach 7.0% in 2008, and with the final month's stats now due I think it is very likely that the 7.0% rate will be broken.

OSO's low estimate: 7.0% (the average the entrail readers estimate)

OSO's high estimate 7.6% (which would equal the highest monthly increase since January 1975, where it increased from 7.2% in December 1974 to 8.1% in January 1975).

If the rate ends up exceeding 7.6% (and these are unusual times, so the chances are that it might) then all those comparisons to the great depression will become even louder.

I think the markets have factored in anything up to 7.2%. Shares and US Dollar are hardly going to move with any rate between 7.0% and 7.2%. Less than 7.0% will be bullish. Higher than 7.2% will be bearish. Higher than 7.6% will see some major moves, especially in the US Dollar.

Regardless of the result, if you're American I would continue to advise investment in Euro, Yen and Gold.

The release will be available here at 0830 EST / 1330 GMT.

25 Predictions for 2009

1. The US Dollar will undergo a substantial devaluation. It will eventually fall below 60 on the US Dollar Index.
   
2. The price of oil will go up again but only because it is denominated in US Dollars. It may potentially rise up to $60 depending upon how far the US Dollar will drop, but will not rise due to increased demand.
3. Oil production throughout 2009 will be substantially lower than the past two years.
   
4. Gold will exceed $1000 per ounce as a result of the dollar drop too.
   
5. US unemployment will exceed 10% sometime during the year.
6. The Dow Jones Industrial Average will drop below 7082.26 (half the October 2007 high of 14,164.53. It's already around 8500 so it won't have far to go).
7. Two quarters of 2009 GDP will be negative. The NBER will not announce an end to the recession at all in 2009.
8. Inflation will rise again a few months after the US Dollar drops (see prediction no. 1 above)
9. Ben Bernanke will resign or will be fired. A major shakeup of the Federal Open Market Committee will see many new faces.
10. US Public Debt will exceed 55% of GDP.
    
11. Barack Obama's decisions will disappoint experts, but will retain a high level of popular support.
12. Paul Krugman will admit he was seriously wrong about something.
13. Iceland's economy will begin to recover in the second half of the year.
    
14. A growing number of Brits will demand adopting the Euro and abandoning the weak Pound. While this number may exceed 50% of the population, it will not be enough for UK politicians to make any decision throughout the year.
15. Australia will lose The Ashes to England in the middle of 2009.
16. More climate scientists will admit that global warming is occurring faster than they thought it would.
17. Sea levels will rise by more than 3mm in 2009.
18. Kevin Rudd will mention Biochar.
19. Applications for Green cards will decline substantially.
20. Linux adoption will exceed 1.2%.
21. Firefox adoption will exceed 25%.
22. Duke Nukem Forever will be released to universal indifference.
23. Robert Mugabe will remain president of Zimbabwe as conditions plumb new depths of misery.
24. The Australian Economy will go into recession.
25. Heath Ledger will posthumously win the 81st Academy Awards Best Actor Oscar for his role as the Joker in The Dark Knight.

Australia likely to be in recession by end of year

Despite all the wonderful protestations by business leaders and politicians about how strong Australia's economy is, bad economic news continues to bubble up.

The latest bit of news is that job advertisements in November 2008 have dropped the most on record. Last week, inflation gauges showed prices dropping quickly in October and November, coming at the same time as the Reserve Bank cut rates aggressively.

So we have a considerable fall in inflation accompanied by a considerable decrease in employment demand. Anyone with ECON101 knowledge knows that those figures together indicate a slowdown.

But then we have to add more, namely the recent GDP figures showing 2008 Q3 growing at a mere 0.1%. If that is revised downwards (and it is possible), then 2008 Q4 - which is already looking to be a negative number - could result in a "technical definition" of a recession (two quarters of economic decline).

So. Who to blame? Kevin Rudd? Despite the fact that the guy hasn't really done anything in his first year as Prime Minister you can't blame him for the current downturn. What about John Howard? The former PM and the coalition government did create some good economic conditions - namely a complete removal of government debt - which will give Rudd and the ALP a lot of room to run sustainable deficits. Howard, though, did help create a housing bubble in Australia with the First Homebuyer's grant and the Negative Gearing tax loophole - but then again Rudd hasn't done anything to remove it since winning the Federal Election 12 months ago.

But, of course, Australia is a small economy that is joined to the rest of the world, and as the economic contagion in the US has spread to Europe and Asia, so it has also spread to Australia.

Having said all that I still have some level of confidence in the Australian economy. We certainly won't avoid a recession IMO, but it will be on the upside (the recovery) that Australia's economic strength (or lack of it) will be shown. Unemployment, for example, will not exceed that of the US.

Confusion

I gotta say, the current state of the world economy is one of complete confusion. No one really knows what is going to happen and no one really knows when things will become less confusing.

I have written in the past about the danger that America faces in terms of Capital Flight. Yet now I see that emerging markets are going crazy and people are cashing out and... putting their faith in the US Dollar.

I still believe that capital flight is a danger - especially with a consensus emerging that the Federal Government should run deficits for a while to stimulate growth. As I have mentioned before, US government debt is one of the more alarming areas of the current crisis because it has yet to really bite.

But bite it will - that much I am certain of. What I am not certain of is its timing. It may be that (barring any miraculous fiscal turnarounds) the world may lose its love of the US dollar a few more years into the future.

By the way, I'm not trying to reinterpret my own predictions of doom and gloom in the face of mounting evidence against them. I'm happy to admit that the emerging markets crisis hitting now was something I did not foresee and which has added yet another missing piece of the final equation. Yes, I was thinking that the US Dollar might collapse within the next 6 months and I now severely doubt that prediction.

But I'm not through with predicting a US Dollar crash yet - not by a long way. The fact is that all the signs are there that the US Dollar doesn't deserve its current value. These include an economy in recession, low interest rates and mounting government debt.

So while I'm happy to say that I'm wrong about the timing, I'm happy to keep with the broad reality that a dollar crash must occur.

It's just that I didn't factor in some dominoes that are falling now. Moreover, the chances are that there are plenty of hidden dominoes out there waiting to fall.

September 2008 Unemployment

Today's unemployment claims are 497,000, seasonally adjusted. That's only 1000 more than last week but the number is still on the high end. Tomorrow will see the unemployment figures for September.

I won't be blogging tomorrow so my usual live blogging of unemployment data won't happen. Click here to visit the official BLS site, which will release the data at 12.30GMT / 8.30 EDT.

Unemployment in August 2008 was 6.1%. I doubt that the rate dropped last month. My prediction is a figure between 6.4% and 6.8%. Considering the wild ride that the US economy has gone through in the last month, I wouldn't be surprised if the figure ends up high that 6.8%. I also think that it is almost a foregone conclusion that October 2008 figures (this month) will see the rate climb beyond 7.0%.

All things being equal

As a predictor of economic and financial gloom it is always tempting and wonderfully schadenfreude-like to say I told you so. In fact, I did this the other day.

But I've got to admit that I did not expect the current crisis to freeze out the credit markets as quickly and as terribly as it has done. My feeling over the past few years has been that the coming recession would be a gradual affair with many stops and starts. I predicted that the driving force behind the slowdown would be Peak Oil, and that the effect of declining oil production would lead to a Depression-like economic hit - though with a difference. What was this difference? Not much deflation, no severe decline in GDP and no big unemployment spikes beyond 20%. Instead, we would see a severe restriction in economic growth over a long period which would see unemployment levels being persistently high but without spiking. Probably the best post I made about this subject was back in March.

Yet somehow my prediction was too conservative. It seems like the US economy was much more fragile than I thought, and the current crisis seems to be leading into a more 1930s type depression with big falls in GDP and big spikes in unemployment.

One of my favourite little phases that I have created is "All things being equal - but all things are not equal". This is, in a sense, a way of describing a "Salient Oversight" - a part of the equation that has been missed. That I should be guilty of a salient oversight is wonderfully ironic.

So what is this salient oversight that I had missed? It began a little over two months ago when I saw this graph:

I even posted about it here.

The first time I saw that graph it frightened the heck out of me. It still does. The reason is not because it somehow disproved my basic belief that Peak Oil would create a horrible depression. Rather, it showed me that the US economy was ripe for disaster anyway.

Let me explain the issue with this graph. The graph shows that US credit market debt exceeds GDP by around 350%. The fact that credit markets have debt levels that exceed GDP is obviously not always a problem - the 1950 to 1980 period never saw credit market debt increase or decline precipitously despite a series of recessions and periods of high and low inflation.

But then, of course, we see the 1930s spike. That spike did not cause the great depression - it was a result of it. Moreover, credit market debt increased during that period not because people were borrowing lots in that period (the opposite in fact), but because GDP was declining while debt levels slowly increased.

And then we see the exponential curve from 1985 until today. By itself, any exponential curve should warn us of terrible danger. The lesson? The US economy was ripe to collapse. The high oil prices from 2004 onwards - brought about by production plateaus being reached as a precursor to oil supply peaking - and the subsequent interest rate hikes was what eventually set off the current crisis.

Back in 2005 I predicted that there were four things which which would create a "perfect economic storm" that would severely damage the US and world economy. These were:

1. Peak Oil
2. US Government debt
3. The collapse of the housing bubble (now referred to as the subprime meltdown)
4. An unsustainable current account deficit
   

In retrospect, the enormous amounts of credit market debt were not a 5th reason I should've added. This is because reasons 3 & 4 - the housing bubble and the current account deficit - were integral parts of the credit market debt. As the curve continued exponentially upwards and the credit market continued to create massive levels of debt, a housing bubble formed along with the desire of the market to invest in US Dollar assets (which led to a current account deficit).

But as I have mentioned before, none of this has removed the threat of Peak Oil. Instead, it has made the situation intolerably worse. Peak Oil was always going to cause a massive economic shift - but that it should occur during a time when the world's economy was already at a turning point is a horrible convergence of events. In many ways I feel like the forecaster who predicted a category 5 hurricane and the deaths of thousands, only for the hurricane to be category 6 (if that were possible) and cause the deaths of tens of thousands.

So now that I am even more gloomy, what will happen?

It is obvious that the current economic crisis will result in a substantial contraction in world economic output. This crisis was of its own making but was set off probably earlier than expected because of high oil prices that were the direct result of oil production plateaus. The economic contraction will inevitably result in a drop in demand for oil, but the danger posed by Peak Oil still remains. Once the world economy begins to recover, oil production issues will stifle growth and economic expansions will be severely limited. Unemployment levels are likely to spike high in places, and in the US I believe that unemployment levels in the "teens" is likely. Moreover, while a recovery will result in employment growth, the continued high oil price of oil will keep unemployment levels uncomfortably high for many years.

Again, the only solution to this is for the US and other countries to follow the austerity guidelines of the Washington Consensus that I have posted about here. Moreover, in order to wean ourselves off oil dependence, nations must invest in public transport and in the design of electric road vehicles.

And as for you, the reader, I simply suggest that you pay off debt as fast as you can and live within your means.