Cyrstal Ball Special by Steven Kyle

One of the benefits of having new writers or guest writers is that they bring a different perspective. Sometimes a completely different style. The post that follows is from reader Steven Kyle.

Crystal Ball Special
Once a year I put my money where my mouth is and predict what the economy is going to do over the coming year. Economists’ predictions tend to be about as accurate as a fourth grader with a ruler and some graph paper would be, but if we are worth anything to society we should be willing to say what we think about the actual economy we have and be graded on it occasionally. I have done this for several years and while last year’s predictions were spot on, there have been some notable mistakes in the past. So here goes – Mark this down and either praise me or point and laugh a year from now.
From the vantage point of early December 2006 it looks like we are now past the peak of the business cycle that began some five years ago. The Fed campaign of tightening is probably at an end (market expectations are for a rate decrease in March) and while the Democratic takeover of Congress has improved the long run fiscal outlook (those recent tax cuts will likely be allowed to expire by 2010 rather than being made permanent as the President wants) the near term outlook is still for huge deficits.
The housing market was the engine of the expansion over the past few years and the end of the housing boom is what is causing the turnaround in the overall business cycle. Various pieces of evidence point to a peak in housing earlier in 2006 and we are now left to hope that the air goes out of the bubble slowly rather than all at once. Either way, with house price appreciation slowing (or even going negative) and household debt service ratios at record highs there is little scope for consumer spending to prolong the economic expansion.
The European area is continuing to undergo a tightening cycle in monetary policy so there is little help to be expected from that direction, while the Chinese economy continues to grow at very high rates. This can’t go on forever but there is no particular reason to name a date when it will end. The big danger is that the Chinese central bank will decide to stop buying US government debt which would cause a drop in the value of the dollar. With dollar holdings already in the vicinity of $650-700 billion they could decide to expand in other directions. This would be significant for the US economy, providing additional downward pressure on the already weak US Dollar (now at 1.33 to the Euro) and upward pressure on interest rates.
Major caveats – Anybody in the Middle East with a grudge and a hand grenade has the potential ability to drastically affect oil prices. Anybody who would be willing to predict that the Chinese will lose their appetite for endless reserve accumulation this year should be willing to issue drastic warnings, but having done so in the past I now refuse to try to mind read the Chinese monetary authorities.
Predictions for the coming year are: GDP growth around 2% (lower if there is a major political or economic shock) inflation continuing around 3% and interest rates likely to come down (at least at the short end) gradually through the year to 4.25% (Fed Funds). The US dollar will likely be seen lower than it now is but where it will end the year is harder to say (though I am betting on it being lower in my personal portfolio). But in the interest of not trying to wiggle out of making a prediction I will step up and say 1.45 to the euro a year from now.
Got your own predictions?