US economy: hard landing or soft landing?

A stream of poor economic data and some horrendous writedowns from the big banks have meant that risky assets have been walloped. The iTraxx crossover has shot out from 340 to 470 since the start of the year, and most of the world’s equity markets are down between 10 and 15%.

The recent release that I’d like to focus on is last week’s Philly Fed number (or the Federal Reserve Bank of Philadelphia’s Business Outlook Survey, to give it its full name), which has been an excellent leading indicator of US growth going back 40 years. Prior to the announcement, market consensus had been for a reading of -1.0, a slight improvement on November’s -5.7. The market consensus got it very badly wrong though, and the Philly Fed number was actually -20.9, the weakest reading for six years. According to my chart (click to enlarge), a reading of -20.9 means a US growth rate of zero should follow.

Looking back over the 40 year history, the Philly Fed survey has only gone slightly wrong as a predictor on two occasions. The first was in Q2 1995, when confidence was dented by Mexico’s financial crisis, which coincided with the Federal Reserve hiking rates very aggressively (the Fed took rates from 3% to 6% from February 1994 to February 1995). The Federal Reserve averted a serious slowdown by cutting rates over the second half of 1995, and the US economy experienced a soft landing rather than a hard landing.

The only other wonky reading was in September 1998, which followed Russia’s default and the LTCM crisis. Although emerging market economies were in turmoil, the US economy was relatively unscathed, helped by the Fed cutting rates very rapidly from 5.5% in September 1998 to 4.75% in November 1998. Despite the financial mess at the time, though, the Philly Fed survey still only fell to -14.1, which is still quite a bit better than last week’s number.

The Fed has applied the usual dose of medicine to this crisis by cutting interest rates rapidly, but will it be enough to prevent a hard landing? I don’t think so. The financial crises of 1994-5 and 1998 came at a time when the US economy was already fairly strong, and it was able to withstand the shock. This financial crisis, however, has come at a time when growth was already weak, and the housing market was already falling. I think the Fed will continue cutting rates to avert recession, but I don’t think it will be enough.