Rapid Downward Revisions in Expected Economic Growth

by: Menzie Chinn October 19, 2008

There have been plenty of accounts that have noted the growing anxiety over economic growth over the short to medium term. However, this forecast from Deutsche Bank, released Friday night, is quite sobering, especially when compared to forecasts released just two weeks ago.

Figure 1: Log GDP, from 26 Sep release (blue line), and implied GDP gaps from WSJ survey (3-7 October survey, green x) Deutsche Bank (3-7 October forecast, teal +), and Deutsche Bank (17 October forecast, red square). Source: BEA, CBO [xls], WSJ [xls], Mayer, Hooper, Slok and Wall, "WO Update: From Financial Crisis to Global Recession," Global Economic Perspectives (Deutsche Bank, 17 October 2008), and author's calculations.

What I find rather remarkable is that over a space of two weeks, we have seen a forecast that was only slightly less optimistic than the mean Wall Street Journal survey forecast (taken over 3-7 October) shift to one much more pessimistic than the most pessimistic one recorded in that particular survey. The sheer rapidity in the deterioration in outlook is also remarkable to me, given that in early October we had been already been a week or so into the credit market freeze.

It is instructive to investigate the implications for the output gap; this forecast implies we will experience an output gap in the area of 7% (in log terms).
Figure 2: Output gap, calculated as log deviation from potential GDP, from 26 Sep release (blue line), and implied GDP gaps from Deutsche Bank forecast (17 October survey, red line). NBER defined recession dates shaded gray. Source: BEA, CBO [xls], WSJ [xls], Mayer, Hooper, Slok and Wall, "WO Update: From Financial Crisis to Global Recession," Global Economic Perspectives (Deutsche Bank, 17 October 2008), NBER, and author's calculations.

Of course, the output gap measure is only as good as one's guess of potential GDP. For more on the technical aspects of this question, see this post. And forecast output gap is only as good as the forecasts as well. But I suspect if the bean counters count the beans in a similar fashion, changes of this magnitude will not be uncommon amongst the forecasters surveyed by WSJ. I would expect the entire distribution of forecasts (shown in this post) to be shifted downward.

There is some solace in the fact that the predicted output gap is less than the one recorded during the 1981-82 recession. And it is substantially less than that recorded during the Great Depression (see the picture in this post, and you can kind of eyeball an output gap in the 30-40% (log terms) range -- as long as you don't believe the Great Depression was a combined leisure and technology shock).

The report summarizes the outlook for the world economy:

Accordingly, we now expect a major recession for the world economy over the year ahead, with growth in the industrial countries falling to its lowest level since the Great Depression and global growth falling to 1.2%, its lowest level since the severe downturn of the early 1980s. We also see a steep drop in global inflation to 3.1% next year thanks to a collapse of energy prices and rising unemployment.

Returning to the US, one of the interesting aspects of the forecast is that the Current Account balance is expected to improve from -4.7 to -3.5 ppts of GDP, while the fiscal balance is expected to deteriorate from -3.2 to -8 ppts of GDP. If one uses the national savings identity:

CA ≡ (S-I) + (T-G)

Then (dividing through by Y), taking total differentials, and substituting in (-3.5+4.7) for Δ(CA/Y) and (-8+3.2) for Δ(BuS/Y), yields:

Δ(S-I) = 6

where BuS ≡ (T-G). That is some combination of saving increases and investment declines must combine to yield 6 ppts of GDP movement.

As this figure from the 2006 Economic Report of the President indicates, such large shifts in the private saving-investment balance have occurred in the past, as recently as 2000-03. But then it occurred over the span of three years, rather than one...and in that case mostly by a decline in investment.

Figure from Box 6-3. Source: CEA, Economic Report of the President, 2006 [pdf].

Substantially increased private saving is consistent with depressed levels of consumption and that in turn is consistent with continued deleveraging in the financial sector, even assuming a satisfactory resolution of the current "credit lock".