by Calculated Risk on 1/02/2007 06:30:00 PM

"The models say 'recession'; the mind says 'no way.' I'm going with the mind."
Edward Leamer, UCLA Anderson Forecast, December 7, 2006

The crystal ball I purchased on Ebay still hasn't arrived, but I suspect it would be cloudy - just like the economic outlook for 2007. Some of the most reliable indictors are waving a red danger flag, as an example:

Click on graph for larger image.

This graph shows the YoY change in New Home Sales from the Census Bureau. When the YoY change in New Home Sales falls about 20%, usually a recession will follow. The one exception for this data series was the mid '60s when the Vietnam buildup kept the economy out of recession.

Note: the New Home Sales data is smoothed using a three month centered average before calculating the YoY change. The Census Bureau data starts in 1963.

But will the housing bust be enough to take the general economy into recession?

“We're having a lot of problems assessing the impact of the housing market on consumers. We know that it's going to dampen consumer activity. We just don't know how much.”
Peter Morici, economist with the University of Maryland, Dec 31, 2006

"How much" is the key question. I think the odds of a recession are at least a coin flip at this point, so unlike Professor Leamer, I'm going with the models. With that in mind, here are my predictions for oil prices, the trade deficit, and interest rates. For a long look at housing, see: Housing in 2007.

Oil Prices: Based on slowing U.S. and world economies, I expect oil prices to fall in 2007. Current the spot prices for WTI are just under $61 per barrel.

Trade Deficit: I expect the U.S. trade deficit to decline in 2007 from the 2006 record of approximately $770 Billion ($643 Billion for through October, 2006). This will be the first decline since 2001.

Economy: Recession. What can I say?

Interest Rates: I expect the Fed to start cutting rates sometime between March and August. I think they will be slow to recognize the downturn, just like in 1990. Still I expect the yield on the Ten Year to be higher by the end of 2007 (currently 4.71%).

Recognizing a recession is hard (almost as hard as predicting a recession correctly). Here are a few quotes from Fed Chairman Alan Greenspan (bear in mind that the recession started in July, 1990):

“In the very near term there’s little evidence that I can see to suggest the economy is tilting over [into recession].” Greenspan, July 1990

“...those who argue that we are already in a recession I think are reasonably certain to be wrong.” Greenspan, August 1990

“... the economy has not yet slipped into recession.” Greenspan, October 1990

I won't mind being wrong, and I hope everyone has a great 2007!