A Framework That Provides Clarity




No Double-Dip Interview

Last month Money magazine published an interview by Ron Insana with ECRI's managing director and director of research titled "Double Dip."

No wonder it's called the dismal science. Until the past month or so, the consensus among economists was that the U.S. economy could take an unusually long time to recover after the popping of the tech-stock bubble and the shock of Sept. 11's terrorist attacks.

But you won't hear much dismay from Lakshman Achuthan and Anirvan Banerji, who head up the Economic Cycle Research Institute (ECRI), an influential little shop whose fans include Fed chairman Alan Greenspan. In fact, Achuthan and Banerji tell me the economy is fully on the mend--and they see little chance of the "double dip" recession that so many economists fear.

Why trust their views over the opinions of others? Because Achuthan and Banerji are right--a lot. Using techniques devised by the late Geoffrey Moore (the economist who in the 1960s invented the index of leading economic indicators), the two are skilled at catching turning points in the business cycle. Indeed, they saw the start of this latest recession six months before it began. And they called a recovery weeks before government officials began suggesting the recession was over.

Insana: How are you two guys different from all the other economic forecasters I talk to?

Achuthan: We approach forecasting from a different mindset. It's a business-cycle mindset: Rather than look for an exact forecast of the magnitude of growth or inflation in the next quarter or two, we focus on whatever trend is in place and try to determine when it is going to break and turn the other way.

Insana: Those breaks are frequently called inflection points. Why are they so difficult to catch?

Achuthan: Economists tend to use standard forecasting techniques that are reliant on regressions and correlations....

Banerji: They are, essentially, linearized models....

Insana: Uh, in plain language, guys?

Banerji: Essentially, what these linearized models do is assume, in a simple or sophisticated way, that whatever has been happening will continue to happen for the near term. In other words, they are projecting the past into the future.

Insana: Why is that a problem?

Banerji: Because a business cycle is essentially what we call a non-linear phenomenon. The turning points in a business cycle are precisely where these linearized-model techniques are guaranteed to fail.

Insana: So tell the folks at home why they should be listening to you.

Achuthan: I wouldn't say that you should listen to ECRI and not to everybody else. I think everybody else is very, very good, particularly between turning points, between the troughs and the peaks. Our forecast is a necessary complement to standard forecasting techniques. In other words, you should check if we see a turning point. If we don't see a turn and we agree with the standard forecasters, then they are very likely to be right--or at least the risk of them being wrong is very low. Then, when we do see a turning point, the risk of that standard forecasting technique being wrong has gone way up.

Insana: You caught the turning point into recession that began in March 2001 and the exit point, which we seem to have just gone through. What were the things in both cases that told you the economy was changing direction?

Banerji: In late 2000 and early 2001 we realized the entire array of leading indexes we follow were behaving in a way only seen before a recession. The same thing happened with the recovery. The leading indexes we track turned up--the whole array, unanimous. The turn was pronounced...

Achuthan: Pronounced...

Banerji: Pervasive and persistent...

Achuthan: The three Ps.

Banerji: This is the kind of behavior we see only before a recovery.

Insana: I understand pronounced. I understand pervasive. But I have trouble with persistence. If you need something to be persistent before you call a turn, won't the turn have occurred by the time you recognize the persistence?

Achuthan: Unless you have a long leading index, Ron! One that can predict behavior well in advance. Our long leading index--a proprietary composite of economic growth indicators--has in the last month reached a 52-month high. This index will typically lead any downturn in the economy by about a year. But as I said, it's now at a 52-month high. So when you have the discussion, "Is there a double dip out there in 2002?," this long leading index says--emphatically--no.

Insana: Does it say that the economy is stronger than many people think?

Achuthan: When you start talking about magnitude, it's beginning to suggest that, toward the end of this year, the economy may actually be accelerating from a weaker recovery to a healthier recovery.

Insana: Not many people are forecasting that right now.

Banerji: I think a lot of this concern about a double dip is misplaced. The one thing this long leading index will tell you way ahead of any other standard leading indicator is whether there's another dip coming. Right now, it's saying very clearly that there isn't.

Actually, this was very helpful back in 1987, after the crash, when a lot of standard leading indexes were suggesting there might be a recession ahead. Our long leading index was very clear: There was no recession in sight.

Insana: Can I use the long leading index to time the stock market?

Achuthan: We don't make market calls. We don't say we have an opinion on stock prices or interest rates. But simply by switching in and out of a broad market index, based on the long leading index, we believe you would outperform a buy-and-hold strategy on a risk-adjusted basis. Whenever you see a recession coming, you know there's probably a bear market coming too.

Insana: Why don't you guys market this stuff? I mean, it seems to be the holy grail of investing!

Achuthan: Because that's not what we do. We're business-cycle forecasters. Our job is very much preserving and advancing and enhancing this business-cycle theory and approach. It's a critical job--if we didn't do it, it might easily fall by the wayside. You know, just a few years ago, very prominent people were saying the business cycle was dead. And we had to stand up to that.

Banerji: The other answer to your question is that there is more to the market than cyclical economic fundamentals. We stick to our knitting and talk about what our data mean for the economy. We let our clients who get the long leading index do their own modeling of the markets if they choose.

Insana: A lot of people worry the Fed is going to raise rates soon. What does your inflation index--you call it your future inflation gauge, or FIG--say?

Achuthan: Look at the three Ps: How pronounced, pervasive and persistent is an upturn in the FIG? In February, that indicator actually moved up--for the first time in a long time--from 26-year lows. But let's put it in perspective, Ron. It's at generational lows.

Insana: Yet the change in direction is what's important, right?

Banerji: Quite right. Going back to the three Ps, however: It is only somewhat pronounced and somewhat pervasive, but it has just turned up for one month, so it's not all that persistent yet.

Insana: Is the gain pretty much due to rising energy prices?

Banerji: No. It is more pervasive than that. That's an important issue. If it had been just energy prices, it would not meet the pervasiveness criterion. You have to have a broad range of the components of this future inflation gauge pushing it up.

Insana: So if it does, in fact, become persistent, what's the typical lag between the time your inflation gauge signals a turning point and the time when the Fed begins to raise rates?

Banerji: The lag time has become somewhat shorter in recent years, but it's typically less than a year. When our FIG peaked in April 2000, the Fed began cutting rates in January 2001, so that was a nine-month lag. That's the most recent turn we have.

Insana: You guys see a bona fide recovery through the end of the year, one that may even accelerate toward yearend from a gentle recovery to something stronger, and you see short-term price stability, although we should keep an eye on that future inflation gauge. Does all this mean clear sailing ahead?

Achuthan: Well, if there is a risk, it comes from investors and others becoming either too complacent or too excited about the emerging environment. That mix of ingredients--strong growth and low inflation--actually holds a big danger in it.

Insana: How so?

Banerji: The big issue that drove the boom-bust of the past five years or so was the idea that the risk of recession had basically disappeared. The danger in the kind of economic scenario we are projecting is that it's the perfect recipe for the cheerleaders of the New Era to say: "Hey, we are back. The New Economy lives."

Insana: Oh, no. Not that again!