Can The Economy Get Worse?

Things are not looking good right now. The stock market is trading at lows not seen over 10 years, and the economy just lost 651K jobs. Downward revisions have been announced for January and February. But should we expect things to get worse?

While reading Bloomberg, Reuters, CNBC and other high frequency news sources it is often difficult to separate the noise from signal. I have therefore recoded a model I was using two years back while working at a large Wall Street firm. Needless to say I no longer work there. Back in January of 2007 the model was saying that the Fed would cut rates at least four times that year. That proved to be pretty much on target. At the time, the consensus view was that the Fed would raise rates to combat rising inflation. The Fed funds rate was one of the things the old model predicted. The new one, of course, is not able to predict Fed funds as that rate simply cannot go any lower. In June of 2007 the model predicted that economy would register close to 0% growth looking one year forward. That proved to be not far from the truth as well.

Here is the model output for 12 month forward predictions:

GDP: -.7%
Intial Unemployment Claims: 430K
CPI Core: 2.1%
ISM Manufacturing Index: 46
Consumer Confidence: 66

As you can see, this is a remarkable improvement over current conditions. GDP for Q1 is currently tracking at close to -5%. Initial claims for February 28 were 639K, ISM is at 35.8, and consumer confidence is at 25, while CPI core printed at 1.7%.

My interpretation of the model output is that in order for the economy to reach 0% growth by Q1 2009 we will need to see things deteriorate at a much slower pace. In other words, there should be a lot less cliff diving than what we have gotten used to over the past few months. Initial claims at 430K suggest that job losses will stop, however, the economy will not be generating many jobs either. CPI excluding food and energy at 2.1% suggest that we will see a bit of an uptick in inflation. It is likely that CPI proper will be higher than CPI core at the time.

It is a little unclear to me what the consensus view is at the moment. Some people say the economy will recover in the second half, and others say the recovery will not start until next year. Since there is no clear consensus the model can't be too far from the consensus view.

Can things get worse that this? The unemployment rate certainly will, but the economy should be contracting at a slower pace over the next twelve months.