2005-Goldilocks Economy(not too hot and not to cold) or Recession?

We live in uncertain times. The Fed is raising interest rates, the dollar is falling and the U.S. is fighting a worldwide war against terrorism. U.S. stock market valuations are high, the bond market is overpriced and most asset classes of all stripes remain overvalued or fairly priced. Not to worry. That seems to be the message emanating from Wall Street analysts, market seers, and other clairvoyants for this year. The panelists of experts promise certainty this year because that is what markets and investors love. This year’s forecasts look more like last year—more of the same: a growing economy and a rising stock market. The only difference this year is that the forecasts have been tempered to reflect rising interest rates. The economy will grow, but at a slightly lower rate. Stock prices will rise, but not as much as last year. In other words, I’m okay—you’re okay— the markets are okay… and there isn’t much to worry about.
This optimism is based on three major assumptions. They are as follows:
1) Oil prices decline and then stabilize.
2) The dollar declines gradually and improves U.S. competitiveness
3) Fed rate hikes are gradual and aren’t overdone.

These are big assumptions. Oil prices may retreat and in fact may head into the mid $30 before rising again. These forecasts assume there are no supply disruptions. With OPEC’s spare capacity now at only one million barrels a day, there is no room for error as we might have with hurricanes, terrorist attacks and the vagaries of weather. As far as U.S. competitiveness, what will another 10% devaluation of the dollar do for the U.S. manufacturing sector that 30% devaluation has not already done? The last time I checked, the U.S. trade deficit was getting bigger not smaller despite a decline in the dollar.

My forecast for the year is simple. Expect the unexpected. The Fed will keep raising interest rates until damage is inflicted upon the financial markets to be followed by eventual damage to the economy. By next year we should be in a recession. I suspect once the markets start to crater and the economy eventually weakens, the Fed will stop raising interest rates unless we are in a full blown dollar crisis. Even then domestic priorities will take precedence over international concerns. As the trend to a weaker economy and financial markets continue, the Fed will then begin to panic.

It is at that time we will have an answer to the inflation/deflation debate. When the financial markets begin to falter and the economy weakens, how likely is it that the Fed will allow nature to run its course? That would mean allowing all debt to be cleansed from the system and the economy and financial markets to be purged from all of its excesses. That’s highly unlikely with an economy that carries $37 trillion in debt with $51 trillion of growing unfunded pension and medical liabilities. When we reach the breaking point some time this year, the Fed and the government is going to throw everything but the kitchen sink at the problem. More money will be created than we have ever seen in history. This will be the beginning of The Great Inflation.

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