Jubak's Journal
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Why we were so wrong about 2005
The economic predictions for this year have thus been way off base. But they may end up simply being very, very early.
By Jim Jubak
Remember how 2005 was supposed to turn out?
At the turn of the year, a consensus of economists, prognosticators, market gurus and various experts without a portfolio -- I'm in one or the other of those categories, I think -- predicted that in 2005 the dollar would fall, long-term interest rates would rise, economic growth would slow and the bond market would tumble.
Halfway through 2005, how could we all have been so wrong?
I don't think the year's second half will redeem that record. To me, it now looks like what the consensus predicted for 2005 has been pushed into 2006, and maybe even the second half of 2006 at that.
Wrong, wrong, wrong and wrong, which is an extraordinary record if you remember how clear the long-term trends looked at the year's start. The federal deficit was stuck at high levels and set to go higher, thanks to a future avalanche of costs that included fixing the alternative minimum tax, Social Security and private pension plans. The trade deficit was at historic levels and creeping higher with no end in sight. Commodity costs were rising around the world, with soaring oil prices a key culprit, threatening to slow economic growth. The Federal Reserve was determined to raise short-term interest rates until they reached a neutral position at roughly 3.5%.
The pesky lag problem
I still think the chickens -- big budget deficits, huge trade deficits and crushing consumer debt -- will come home to roost. The dollar will fall, interest rates will rise and the economy will stumble -- just later than everyone predicted. The predictions made at the beginning of 2005 were a victim of lag, one of the worst problems in economic forecasting. Economics is relatively good at telling us what should happen next, but it's downright awful at telling us when next is. For example, if consumers keep borrowing more and more to spend more and more, at some point, economics says, the debt pyramid will come crashing down. But is "some point" the second half of 2005, 2006 or 2010?
If you study that nature of the lags that derailed the predictions of January 2005, that "some point" looks likely to be 2006. Maybe mid-2006.
Consider the mess that has swallowed the euro in the last few months. Slowing economic growth in Europe -- slower than in the United States, for sure -- and lower interest rates had taken a 5% bite out of the euro by the end of March. And then came the dustup as French and Dutch voters said "no" to a new European Union constitution. Knock another 5% off the euro.
And what has been bad for the euro has been good for the dollar.
It's not so much that the dollar looks so much better than it did in January. The United States still faces huge budget and trade deficits. In fact, the April trade deficit climbed to $57 billion after the monthly deficit had dropped to a revised $54 billion in March. But some of the fear that Asian banks would start dumping their dollars to buy euros has dissipated now that so much uncertainty swirls around the euro.
We haven't yet seen a peak in worry about the euro, either. With a good chance that next week's European Union summit will end in bitter fighting between British Prime Minister Tony Blair and French President Jacques Chirac, and that the government of Germany's Gerhard Schroder faces defeat in elections scheduled for the fall, it's hard to see the political turmoil that's now driving the euro's decline ending before the fourth quarter. BNP Paribas now sees the euro falling to $1.16 by the third quarter from the current $1.22, before it begins a recovery to $1.28 by the first quarter of 2006. That seems a reasonable scenario, especially if the Federal Reserve keeps raising short-term interest rates in June and August to 3.5%, and the European Central Bank finally cuts interest rates to revive economic growth. Higher U.S. interest rates compared with those in Europe would support a stronger dollar.
Of course, a strong dollar, which hurts U.S. exports, and higher interest rates at home, which damp domestic spending, do add up to lower economic growth in the United States. Not all at once. And not by a huge amount. But the drop from 4% growth in the third quarter of 2004 to 3.8% in the fourth quarter to 3.5% in the first quarter of 2005 does put the economy on a path that leads to growth nearer 3% by 2006.
The role of globalization
The big wild card in predicting anything about the economy these days is long-term interest rates. When the Federal Reserve raises short-term interest rates, long-term bond rates are supposed to climb. Historically, a two percentage-point climb in short rates, for example, has led to a one-percentage-point climb in long-term rates. This time around, however, the Federal Reserve has raised its target for short-term rates by two percentage points -- to 3% from 1% -- in the last year, but yields on the 10-year Treasury note have tumbled to 3.9% from 4.7% in June 2004.
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