Tuesday, January 04, 2005

2005 economic forecast 

It's the season for forecasts, and as I mentioned yesterday that I was working on some. That means I ran some models I use on the St. Cloud Macro Forecasting Project when I teach forecasting here, which unfortunately I have not had time to teach for awhile. I run the models twice a year to be sure they are still performing adequately and to inform my thoughts on the local economy for the St. Cloud Quarterly Business Report.

This process is always edifying. One of the lessons I teach students is that models will help you hang numbers onto a story but they can never replace a story. That is, if you just write down the results of a model and can't explain why they occur, you will never be a good forecaster. That's because a good forecaster will be wrong often, and needs to explain the reasons for error. Take a look (if you have a subscription) at the number of people who forecasted the U.S. economy last year and how many that got it wrong. You have to be able to explain yourself to keep your job.

I'm not far from the average for GDP growth in 2005. I'm about a half-percent higher in GDP growth than the forecasters in the WSJ. I will say GDP grows 3.75% to 4.5% in 2005, whereas their average was 3.5%. I show unemployment falling a bit more than they do, with a December 2005 reading of 4.7%. My estimate for CPI inflation is a bit higher than theirs, with about 3% increase in prices. This is based on a guess that the Fed will stay a little on the loose side with monetary policy, so that the Fed funds target will not get above 3.25% before the end of 2005.

Why would I say that?

This gets to the rest of the story. I mentioned yesterday Arthur Laffer's editorial on the dollar and the trade deficit. I jumped to read it first yesterday morning -- even skipping over ForecasterFest '05, which takes some doing -- not just because Laffer is one of my favorite economists but also because he was writing about something I was thinking about with my forecast. Here's part of the rest of what he said,

The dollar under current circumstances can't go to zero or infinity. Without a corresponding rise in domestic dollar prices, U.S. goods and assets become relatively more attractive to foreigners and Americans alike when there is a fall in the foreign-exchange value of the dollar. Sooner or later the dollar would be such a bargain that there would be more buyers than sellers, therefore limiting the dollar's fall. Today, the dollar's value in the foreign exchanges fits nicely within its historical range.

On Jan. 1, 1999, the euro was born and was worth $1.17. In fact, if we look at the synthetic euro prior to 1999, the dollar's low was in 1992 when each euro could buy $1.47. The large dollar appreciation from 1992 to early 2002 saw the dollar peak at 83 cents per euro and our capital surplus (the trade deficit) go from less than 1% of GDP to almost 4% of GDP (and continue on to today's 5.6%). Well, the global economic environment is changing once again as are investors' perceptions of relative attractiveness.

There have been times in the past when the dollar depreciation of the magnitude we've experienced over the last two-plus years would have been a clear harbinger of much higher inflation and interest rates. But such is not the case today. It is true that products which are freely traded in global markets will experience dollar price increases relative to foreign prices by the percentage depreciation of the dollar. But to have these exchange-rate induced price increases lead to higher U.S. inflation would require the Fed to accommodate the higher inflation with faster monetary-base growth. The Fed has not accommodated any higher inflation and as a result
markets do not anticipate higher inflation. Nor should they.

I fairly gasped when I read those lines I italicized, because it fit. I do not see another economy stepping in and attracting all that quicksilver capital that is seeking high returns on the market. If it comes here, not only must our assets hold their value, so too must the dollar. Part of my hesitation is that The Economist is saying almost exactly the opposite of this forecast, but I've decided they are wrong this year. That has led me to the following set of predictions:
I close with this thought: As an academic, I do not forecast for a particular company, or for a portfolio, or for anything other than the sheer fun of the exercise. Not having something riding on a forecast gives me some ability to step out relative to those who forecast for investment houses and banks. Going against the grain is a benefit in this case so as to be noticed. So if this thing seems outlandish to you, remember I have no money riding on the outcome; neither should you based only on what you read here.