There’s a Giant Contradiction at the Heart of the U.S. Economy

Suppose you told an economist these facts and only these facts: Long-term interest rates have fallen sharply over just a few months. Prices for oil and other much-needed commodities have been in free fall in the face of weak demand. Markets are predicting that inflation will be low in the years ahead and that the central bank will keep interest rates lower for longer.

Knowing only those facts, the economist would conclude that this country was staring down the barrel of a significant economic slowdown, and maybe even a recession.

What would that economist conclude, though, if stock prices are consistently rising toward record highs, job gains are the best in years, corporate sales and profits are rising, and business surveys and other real-time indicators of the economy point to steady expansion?

That country, of course, would seem to have a perfectly strong economic outlook. And as you have surely guessed, both these situations apply to the same country at the same time, which is to say the United States in November 2014.

Photo

Credit Joel Plosz

This is the central paradox of the economy as the year nears its end. And the giant question facing the United States going into 2015 is which set of indicators are giving a more accurate view of where things are headed. In one telling, the nation is on track for the strongest year since the recovery began over five years ago; in another, Americans should brace for yet more sluggishness and uncertainty.

Looking solid as well are those pieces of data that usually serve as advance warning that the economy is faltering. The Conference Board’s index of leading economic indicators rose a healthy 0.9 percent in October and hasn’t logged a monthly decline since January. The stock market rally continued Friday after moves by the People’s Bank of China and European Central Bank that signaled easier money ahead.

The trouble, if it can be called that, is in the corners of the bond and commodity markets that often presage problems in the economy.

When investors become more concerned about the economic outlook, they tend to shift money into bonds, tolerating lower yields in exchange for safety and the expectation of lower interest rates in the years ahead because of the weak economy. For example, a sharp decline in yields during the second half of 2007 foretold the recession that began in December of that year.

The yield on 10-year Treasury bonds has fallen to 2.31 percent as of Friday, from 3 percent earlier in the year.

And while the price of oil and other commodities is influenced by many factors other than the overall state of the domestic economy (supply, weather and so on), the steep sell-off since this summer has been an indicator that global demand is considerably weaker than had appeared likely as recently as the spring.

There are three basic ways to resolve the contradictions among these pieces of data, each with different implications for the United States economy in 2015 and beyond.

It’s All Overseas

Maybe the moves in bond and commodity markets reflect a shortfall in economic growth outside the United States, and the American economy will continue to hum despite weakness almost everywhere else.

In this telling, the drop in bond yields and oil prices actually has little to do with what is happening in the United States, but rather is driven by the persistent weakness of the European and Japanese economies, paired with disappointing growth in once-strong emerging markets, including China and Brazil.

Weakness in those economies is creating a downdraft for commodity prices and stronger expectations of deflation, or falling prices, for years to come. Against that backdrop, Treasury bonds look like a good deal, despite their falling yields, because inflation is expected to keep coming in low, even as the American economy heats up. That globally driven low inflation will lead the Fed to keep interest rates low for longer.

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The Central Paradox of the American Economy

The economy is doing pretty well if you look at most economic data or the stock market. But commodity markets are flashing warning signs about what is to come.

Indexed to level on June 30, 2014

Oil price is for West Texas Intermediate crude in Cushing, Okla.

Source: Energy Information Administration, Standard & Poor’s

Even if this narrative is correct, though, it raises a worrying problem: How long can the United States remain an island of solid growth in the face of a slumping world economy?

Markets Are Distorted

Maybe the various market-based indicators of where the economy is going are sending misleading signals because of idiosyncratic circumstances.

In this telling, the stock market and bond market are both booming simultaneously primarily because global central banks either already are (Bank of Japan) or soon will be (E.C.B.) engaged in large-scale buying of securities through quantitative easing.

And the commodity sell-off, in this telling, is less a signal of future economic weakness and more a consequence of factors peculiar to those markets. Supplies of oil are rising because of the American and Canadian energy boom. Supplies of corn and other agricultural products are booming thanks to better weather during the growing season this year.

And these two trends reinforce each other. Falling commodity prices mean lower inflation, which makes bonds more attractive, driving bond yields down further.

If this interpretation is correct, the markets aren’t telling us much at all about the economic future.

A Slowing U.S. Economy?

Perhaps the situation in the United States is gloomier than the conventional economic measures are telling us so far. It could be, in this version, that this is a bit like the second half of 2007, when market measures pointed to a downturn but a recession didn’t begin until December.

The drop in oil prices may partly reflect that industry in the United States is demanding less energy than in the recent past as it anticipates weaker demand. Perhaps the bond market knows something that just hasn’t shown up in the official economic statistics yet.

Macroeconomic Advisers, a leading forecasting firm, has cut its estimate of how fast the economy is growing in the fourth quarter (now about midway over). It pegs it at 2.2 percent, down from 3 percent, and its November forecast has overall economic growth for the year below its previous estimate by half a percentage point.

If economic data remain strong over the next couple of months, it may be safe to toss out this possibility, but until then, the darkest timeline has to be considered, given the mixed messages that the global markets are sending.