Alex and Dave's Economic "Fore-guess"

Farm Business Management Update, June/July 2006

By Alex White (axwhite@vt.edu), Extension Specialist, Finance, and David M. Kohl (sullylab@vt.edu), Professor Emeritus, Department of Agricultural and Applied Economics, Virginia Tech.

We’ve been getting a lot of questions concerning what’s in store for the U.S. economy. Mainly, these questions deal with interest rates, the stock market, inflation, and a possible recession. After examining a few of the major U.S. economic indicators, here’s our best guess as to the future of the U.S. economy.

We see inflation rearing its ugly head at the moment. We have six main reasons to expect higher inflation in the economy over the next six to eight months:

1. The Unemployment Rate has been slowly decreasing over the past year. More people in the workforce are earning and spending money. More money in the economy may lead to inflationary pressures.
2. The Purchasing Managers Index (PMI) is relatively strong and has been increasing since 2005. This index indicates a positive outlook for the retail industry, a reflection of relatively strong perceived demand by U.S. consumers.
3. The Capacity Utilization Rate is relatively strong and increasing. This rate measures the percentage of production capacity that manufacturers are currently utilizing. An increase in this rate indicates that producers are gearing up their production processes to meet higher expected demand for their products. It also means they may start hiring more workers to meet the increased production. Both of these factors indicate inflationary pressures.
4. Oil prices are well above the long term average, leading to increased costs of gasoline, oil, heating fuel, chemicals, and other petroleum products. These increased costs are especially scary for agricultural producers!
5. The Core Inflation Index is increasing. This index measures the cost of living, excluding food and energy costs. Compound this increase with the surging of gold and copper prices, which have more than doubled in recent years, leads investors to predict future inflation.
6. On a special note, the recent minutes from the Federal Reserve indicate a balanced economy but with inflation bias. One of the main goals of the Federal Reserve and Chairman Bernanke is to maintain inflation rates under long term averages of 4 percent.

• The stock market is showing signs of life, in part due to the perceived increase in demand for U.S. goods. Increased production hopefully leads to increased profits, which in turn may lead to growth in corporate stock prices.
• We do not see a big threat of increased unemployment in the near future. Again, as manufacturers are increasing their production, look for the unemployment to possibly drop slightly.
• In looking at the ratio of 30-year mortgage to 3-month treasury note yields, we’re starting to see a flat yield curve. This flattening yield curve is a signal of slow growth in the economy over the next six to eight months.

• Continued slow growth in the economy;
• The Federal Reserve Board to inch up the Federal Funds Rate to try to curb inflation. It could possibly be 5.50 to 5.75 percent by year end if the inflation bias continues, and interest rates on consumer loans and adjustable rate mortgages will probably start to increase.
• Increases in the everyday cost of living – not just gasoline, but in all consumer goods. You may want to increase your inventory of non-perishable goods now before the cost increases significantly.

1. Oil prices are higher than the long term average;
2. Interest rates are increasing; and
3. The yield curve has been flat to slightly inverted, that is, short term rates are equal to or higher than long term rates.

Since 1971 these three factors have predicted every recession. Why not this time? Housing and real estate appreciation have fueled refinancing strategies to pump liquidity into the economy. Last year housing and real estate pumped nearly $1 trillion into a $12 trillion economy. So goes housing and real estate; so goes the economy!

Visit Virginia Cooperative Extension