Wednesday, September 29, 2010

The New York Fed is about to Blow Another Forecast

The last time I wrote in detail about the New York Fed was in 2004, I basically called them idiots for issuing a paper that said there was no housing bubble. I'm back. This time I am focused on their forecast that there is little chance of the economy going into a double dip recession in 2011.

The methodology they use to reach this conclusion is typical econometric confusion. They look at data but fail to understand the workings of the data outside of simple correlations.

Mark Perry writes:

The New York Federal Reserve updated its "Probability of U.S. Recession Predicted by Treasury Spread" yesterday with treasury yield data through August 2010, and the Fed's recession probability forecast through August 2011. The NY Fed's Treasury model uses the spread between the yields on 10-year Treasury notes (2.70% in August) and 3-month Treasury bills (0.16%) to calculate the probability of a U.S. recession up to twelve months ahead  using the spread between those two yields (2.54% in August).

The Fed's model shows that the recession probability peaked during the October 2007 to April 2008 period at around 35-40%, and has been declining since then in almost every month. For August 2010, the recession probability is only 0.08% and by a year from now in August of next year the recession probability is slightly higher, but only 0.61% (about 6/10 of 1%). According to the NY Fed Treasury Spread model, the chances of a double-dip recession through the middle of next year are essentially zero.
The "yield spread" used to be one of my favorite indicators because when short-term rates were lower than long-term rates, banks used to borrow short-term and lend long-term with reckless abandon. Thus, you knew the economy was going to be in a Fed inspired manipulated boom phase. BUT, you really need to understand this causal relationship between low short-term rates and banks lending money out. That's what fueled this indicator.

Econometricians who simply look at the correlation between low short-term rates versus long-rates and a boom economy, without understanding the underlying dynamics, set themselves up for embarrassing forecasts that have little contact with reality.

The current environment is such an environment. Short-term rates are below long-term rates BUT the banks aren't lending the short-term money out. They are putting the funds on deposit at the Fed as excess reserves. There is a trillion plus in excess reserves. That money is not in the system bidding up prices. Thus, the NY Fed is way, way off on its forecast that there is zero chance of a 2011 recession. If the current situation holds, we will likely have a recession. It would take Bernanke to increase money growth, fairly soon, at a annualized double digit rate to halt a second down leg.

I am really not impressed at all with the work coming out of the NY Fed. The Fed economists are off on this very simple concept, just as they were off on their absurd argument that there was no housing bubble. These guys are somewhere between mental midgets and guys who are intimidated into using no balls faulty analysis that most others are using.

It's a damn good reason to close down the entire NY Fed research department (Along, of course, with the rest of the Fed).

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