Where is the U.S. in the Economic Cycle?

By The Curmudgeon

Are almost all U.S. economists looking at their world through rose- colored glasses?  We think so.  In our view, risky loans, excessive leverage, stubborn consumer inflation, slow economic growth and unexpectedly low productivity growth may at some point cause a financial market crisis.  If that were to occur, then all the happy talk and soothing economic outlooks would be of little help.  Having already commented on the risky loans and leverage in the system, we will deal with fundamental economic issues in this commentary

We see a number of current problems that could cause financial market havoc in the future:

1. Headline inflation has been accelerating.  The Consumer Price Index for all Urban Consumers (CPI-U) increased 0.2% in June, while the core CPI-U also increased by 0.2%. The CPI-U was 2.7% above its level in June 2006, but it has risen at an annual rate of 5.0% in the first half of 2007.

Fed Chief Ben Bernanke seems to be singularly focused on the core Personal Consumption Expenditures (PCE) deflator, which has risen 4.4% for the first 5 months of 2007.  The core PCE is an implicit index -- its weights change based on changes in consumer buying patterns. When prices rise, consumers tend to find lower priced substitutes and these substitutions help keep this inflation gauge down.  Of course, there are certain items that are not counted in the core PCE, for which there is no substitution.  Those items, e.g. gasoline, heating oil, milk, food, college or health care are rising sharply.  This means that the Fed's favorite inflation gauge is not measuring true inflation.  Hence, it is broken and we don’t think it should be relied upon anymore.

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So for over one year, Bernanke keeps saying he hopes inflation will come down, but it  has not done so.  Yet, the bond vigilantes are evidently asleep, as they have pushed the yield on the 10 year T Note under 5% (a negative real return, based on the CPI-U for this year).

2. Productivity growth has been well below its historical average since the fourth quarter of 2005. Second-quarter gross domestic product and productivity figures, which will be out at the end of July, will probably reflect continued sluggishness.

3.   Economic growth has been declining, mostly because of the deterioration of the housing market. June housing starts were 19% below the year-earlier period and building permits were down 25%. Since employment data has been quite strong throughout 2007, a weak GDP figure will signal abysmal productivity growth.

4.  The US dollar is in another leg down- setting new all time lows against the Euro and 27 year lows against the GBP and Canadian dollar.  No one seems to be paying attention to this.   The declining dollar lowers our standard of living in the U.S. as all imported goods and services now cost more in dollars.


If productivity growth is weak, inflation will be higher than would be historically expected, given the level of economic growth.  Continued high commodity prices will eventually drive consumer prices higher as the cost is past through to finished products.  The declining dollar will also raise inflation as imports will be more expensive and competing US manufacturers will have an incentive to raise prices on equivalent goods and services.

Where are we at in the economic cycle?  Inflation this year is accelerating, productivity is weakening, the dollar is declining sharply, and a speculative mania in buyout/LBO/private equity deals has been artificially boosting global equity markets (but we think that has finally ended- please see yesterday’s commentary).   We see the current period as one of stealth stagflation, with stubbornly high inflation and low economic growth.  We think that monetary policy is way too easy and should be significantly tightened – especially in the U.S. and China.   In the U.S. and Europe, too much newly created money has been going into loose loans for buyouts and leveraged speculation in other asset classes. (For four years, every asset class has had a positive total return).   Such rampant speculation has always caused economic dislocations and has resulted in hard landings for the economy and financial markets.

Does anyone remember when the dot-com bubble burst?  And the aftershocks that followed?  Perhaps, we are in an echo bubble now that is just about to burst.

The Curmudgeon