JMK's Modal Economic Outlook

I feel as though I'm long overdue for some reasonably productive content--and I'd hate for efforts from Coletrain and others to reinvigorate intelligent discussion to be in vain--so here's another of my forecasts, san complex forecasting models because, frankly, I don't have the time.

This is potentially an interesting year for the global economy. To review:

1. The ECB unveiled a QE program earlier this year, committing to purchasing 60 billion euros of bonds a month until at least September 2016, with the ability to extend the program beyond that date if necessary. Draghi is largely expected to expand the size, duration or composition of this program at the upcoming December meeting.

2. China has been on the verge of imploding multiple times, and the spillovers -- particularly to emerging markets -- are potentially dire, especially since, as the largest global consumer of raw materials, it's put a considerable dent in commodity-exporting EME's like Russia, Brazil, etc. The stock "correction" -- 10% fall in the Dow -- late summer that deterred the Fed from lifting off in September was largely driven by fears of a rough landing in China, the probability of which the IMF recently suggested was overblown: services, for instance, remain fairly robust, and those numbers probably speak more to the future of the Chinese economy than the weak manufacturing numbers due to the changing composition of the Chinese economy. The PBOC has slashed rates six times since November of last year and loosened reserve requirements several times. The PBOC also depreciated the yuan by about two percent in August -- though not long after sold off a record number of foreign currency reserves and strengthened capital requirements in order to boost it ex post facto.

3. Several emerging market economies are trapped between a rock and a hard place. Many of them, due to their rapid industrialization in recent years, are heavily -- and overly -- focused on savings/investment over consumption, have considerable current account deficits, and are heavily dependent on the post-crisis capital inflows from the U.S. (after interest rates fell to zero as a search for yield). They've also overborrowed, according to estimates by the IMF, to the tune of about $3 trillion -- much of which is denominated in dollars, meaning that if/when the Fed lifts rate, we would observe three consequences: a rise in borrowing costs (capital flows out of EME bonds), depreciation of EME currencies, and corporate defaults. Exports might rise, all else equal, but the net capital outflows will likely serve as a net negative; the consequences will likely rival that of May-June 2013 (branded in financial markets as the "Taper Tantrum").

With the recent robust October jobs report in the US, enhanced stimulus efforts by the PBOC/Swedish Riksbank, and expectation of stimulus in the ECB (all of which constant a de-facto firming of U.S. policy, btw), reasonable rebound in financial conditions, and lessening fears of global spillovers, the U.S. Fed is largely expected to follow through on its earlier forecast of a December rate hike. The problem, of course, is that it's been telling us it would firm for a long time. It usually is a self-defeating prophecy:

1. Fed primes markets and says it will firm unless stuff hits the fan.
2. Financial markets flip out, financial conditions tighten -- which constitute a de-facto tightening.
3. The Fed says, "Well, look at that... financial markets did the job for us. If we tighten, we send the signal that we want the economy to slow *further* than it already is," and stays the course.
4. Financial conditions loosen, economy perks up.
5. Fed says it wants to lift.
6. Lather, rinse, repeat.

Much of the tightening in late August was due to the expectation of tightening in September, but the inextricable moving part was weak growth in China. With China evidently on more stable footing, there's far less of a risk of spilling over to the U.S. -- though emerging markets, I'm afraid, are horribly positioned. The Fed also faces the risk of saying, "We're totally going to do it, we're going to do it, we're serious this time!", in which case failing to move in December would be seen as reneging on past guidance, state-contingent though it was.

Therefore, my forecast is as follows: I am 99.999% sure that the Fed will raise the fed funds rate to 25 to 50 basis points at its December meeting.

There are several caveats and qualifications to this forecast: if stuff hits the fan, they probably won't do it; if Yellen thinks there will be three dissents -- Tarullo, Brainard, Evans -- she's likely to hold off; if EME's implode ex-post-facto, they might renege. But I cannot envision a scenario where they opt to hold off further than December of this year, especially when the composition of the voting FOMC next year changes in a considerably more hawkish direction -- in which case moving in January, sans a prescheduled press conference, is increasingly likely; they might be better off biting the bullet with a December lift.

The results of this move are somewhat uncertain, but if I had to guess, here's what I think will happen:

1. EME's will be hit really, really, really hard.
2. The Fed will acknowledge that the spillovers are relatively small, and probably won't care all that much.
3. Commodity prices will stabilize sometime around next year, and inflation will move back to 2 percent not long thereafter.
4. As it moves back, the Fed will flip out and jack up rates at a faster pace than the currently projected once-per-quarter pace.
5. That will backfire royally, and they'll slow down, such that we end up slightly lower than their end-of-year 2016 forecast.
6. Trend growth is trapped somewhere below 2 percent, and unemployment falls even further below the Fed's projected 4.8 percent range next year -- as they have underestimated employment gains every year for the past six years. This suggests that they're overly optimistic on the outlook for productivity/potential, in which case there's a better case for lifting, insofar as there's a reasonably high Phillips curve coefficient (hint: there isn't.)

Basically, nothing all that interesting will happen: the Fed will lift rates, things won't explode (that much), though financial markets will throw a few tantrums that the Fed will probably -- and should -- ignore almost completely.

Economics is boring... the ideal forecast is "everything will stay almost exactly the same, except for my 10 other hands saying otherwise."

Crapppppppppp, wrong forum. This should've gone in "current affairs." Feel free to move this, Lars.