Most accurate forecaster: Kinder, gentler economic outlook

Despite dire predictions that the price of oil, the recent credit crisis and the ailing housing market will bring the U.S. economy to its knees, one prominent economist has faith in its resilience. Dr. Ken Mayland, recipient of the 2007 Lawrence R. Klein Award for Blue Chip Forecast Accuracy, concedes that in some areas of the economy the U.S. has yet to hit rock bottom, contributing to the potential for recession in the coming year. But many economists and analysts have wrongfully magnified the level of the nation's economic risk, he says.

Despite dire predictions that the price of oil, the recent credit crisis and the ailing housing market will bring the U.S. economy to its knees, one prominent economist has faith in its resilience. Dr. Ken Mayland, president of Ohio-based ClearView Economics, concedes that in some areas of the economy the U.S. has yet to hit rock bottom, contributing to the potential for recession in the coming year.

But many economists and analysts have wrongfully magnified the level of the nation's economic risk, he says. "The masses tend to get tunnel vision when it comes to economic forecasting. They focus only on the issue of the moment, exaggerating the impact and ignoring the offsets," explained Mayland.

As the winner of the 2007 Lawrence R. Klein Award for Blue Chip Forecast Accuracy, Mayland's economic words of wisdom carry considerable weight. Mayland received the award this week at a ceremony in New York City, hosted by the W. P. Carey School of Business at Arizona State University.

Named for Nobel Laureate Lawrence J. Klein, considered the creator of modern economic forecasting, the annual award recognizes accuracy and consistency in forecasting. Klein, who was one of Mayland's graduate school professors at the University of Pennsylvania, attended the ceremony and presented the award to Mayland for producing the most accurate economic forecast among Blue Chip survey participants for the years 2003 through 2006.

Mayland and 49 other economists submit forecasts in four key indicators — gross domestic product (GDP), consumer price index (CPI), unemployment, and the Treasury bill rate — each month in the Blue Chip Economic Indicators newsletter.

Mayland's particular strength was in predicting the Treasury bill rate, an area Lee McPheters, senior associate dean of theW. P. Carey School of Business, called "particularly treacherous" in his opening remarks. The four-year average error between Mayland's forecast and the actual value for the Treasury bill rate was a remarkable 0.125.

Lessons from the current economy

In his presentation at the ceremony, Mayland picked apart the three main factors that have been hampering the economy — the housing decline, the credit squeeze and rising oil prices — to separate truth from hysteria and offer his own predictions. His overall theme? These issues will likely get slightly worse before they get better, but taking a closer look at the metrics reveals that the economy is not as bad off as it may seem.

Take annualized housing starts, for example. Now at roughly 1.2 million, housing starts are down significantly from the 2.2-million peak at the beginning of 2006. But Mayland pointed out that housing starts were below one million in 1975, 1982 and 1991 — other down periods for housing. This is a positive sign for the current housing situation, he said.

"Housing starts are not going to zero," he told the audience. "While we may not have hit the bottom yet, one of the conclusions I draw from the data is that much of the decline of the housing industry is behind us. Therefore, the drag on the economy in 2008 should get progressively lower." Mayland foresees a further drop in home prices, estimating that when the market hits bottom, prices will be some 10 percent to 15 percent lower than at the peak of the housing boom.

But more important than the prices themselves, said Mayland, is the fact that dropping prices have not caused the expected negative wealth affects. Interestingly, after a string of years of home-price increases, people are not behaving as if the most recent increase in home wealth was permanent, he noted. "The last 10 percent of wealth people accumulated from rising home prices, they viewed as 'funny money,'" Mayland said.

"So as a result, many homeowners are viewing the first 10 percent loss of wealth associated with declining home prices as giving back the funny money they never thought was permanent to begin with." A similar story can be told in the credit markets. This summer's subprime mortgage meltdown left economists and business observers alike asking what went wrong. Mayland believes one part of the problem is that credit risk was priced too cheaply.

typical cyclical relationship between credit spreads and industrial production/economic growth sees credit spreads tending to be lowest when industrial production and economic growth are at their highest, and vice versa. In contrast to that pattern, numbers from the summer of 2006 through this past winter showed a sharp slowdown of industrial production, yet credit spreads remained close to historic lows. An adjustment in credit risk pricing, therefore, was somewhat inevitable.

"And like making sausage," Mayland joked, "the re-pricing of credit risk is not a pretty sight." What is a pretty sight is the fact that outside the subprime niche, consumer loan delinquency has remained largely under control. Overall loan delinquency at all banks is up, but is not as high as it was, for example, during the second half of the 1990s — a time when the economy was considered quite robust.

In addition, commercial credit quality is stronger than it has been in decades, Mayland pointed out. Banks that make and hold mortgages are also reporting low mortgage charge-off levels, he noted, singling out Fannie Mae, which posted August 2007 delinquencies of 0.7 percent.

Oil prices make up the last area in the trifecta of bad news that Mayland believes has been exaggerated by many economists and the press. Consumer spending has remained fairly resilient even in the face of recent $90-per-barrel oil prices, he observed. The popular wisdom is that rising oil prices will eventually cause a decrease in consumer spending on discretionary items, which ultimately drags down the economy.

That's because oil is a non-discretionary item — consumers have to fill up their cars with gas and must heat their homes in the winter. Here again, Mayland offered a different take: "what goes around comes around." The current relationship between consumer spending and rising oil prices can be explained by the so-called circular flow of income and spending — something, Mayland says, too many economists forget about.

"Someone's increase in spending eventually becomes someone else's increased income," he explained. Though the U.S. imports most of its oil, the U.S. produces, refines and distributes a lot of oil domestically, which creates value for the energy industry, and in turn, investors and the consumers working within that industry.

The same theory may also be applied to mortgages, Mayland noted. "Too may people think in terms of partial equilibriums instead of looking at the general equilibrium. They focus on a narrow situation and don't consider the big picture," Mayland said. "The economy truly is complex creature with lots of interrelationships that affect how conditions play out over time."

What to expect next

As the Lawrence Klein Award winner, Mayland has proven his prowess at determining how those conditions play out over time. So, what are his expectations for 2008? Is the U.S. economy headed for a recession? Placing the risk of recession in context is the first step, he noted. Historically, most recessions have resulted from a combination of similar preconditions: stretched balance sheets, bloated inventory levels and high inflation rates.

Applying that check list to the current economy, it is clear that these preconditions do not currently exist. "Corporate balance sheets are in great shape; consumer balance sheets are in pretty darn good shape; inventories are in better shape now than they were a year ago, showing a pretty good balance with sales; and inflation rates, for now, fall within the Fed's comfort zone," Mayland explained.

Though the U.S. economy is facing some tough challenges, it weathered catastrophic events in recent years (including the stock-market crash of 1987 and the Long Term Capital Management crises in 1998) without sliding into recession. This leaves Mayland confident that we will steer clear of recession next year. His specific forecast for 2008 remains more hopeful than those of his Blue Chip peers. The Blue Chip panel lowered its outlook for 2008 GDP growth from 2.9 percent in July to 2.4 percent in November.

Mayland, who predicted 3.1 percent 2008 GDP growth in July, lowered his forecast to just 2.9 percent growth. "I am pretty happy with my numbers; I'm where I want to be versus the consensus," he said. The stage is set for Mayland vs. the masses in 2008. If his recent forecasting prowess is any indication, a kinder, gentler economic outlook may play out over the next 12 months, which would be good news for both Wall Street and Main Street.

Bottom Line:

• Dr. Ken Mayland, winner of the Lawrence R. Klein Award for Blue Chip Forecast Accuracy, predicts that the U.S. will likely avoid recession in the coming year despite some daunting economic challenges.
• Dropping real estate resale prices have not caused the expected negative wealth effects as homeowners apparently considered some of the run-up to be impermanent.
• This summer's subprime mortgage meltdown was due in part to the fact that credit risk was priced too cheaply.
• Oil is pricey, but the current relationship between consumer spending and rising oil prices can be explained by the so-called circular flow of income and spending. High oil prices create value for the domestic energy industry, and in turn, investors and the consumers working within that industry.