Simonoff: Do you think that we are done? When the Fed starts cutting interest rates, how far do you think they will go?

Chitnis: No, I don't think that we are definitively done because, as I said, this feedback loop mechanism. I think the Fed is going to be in a bit of a wait-and-see posture. The bond market is a little bit too far, too fast. The bond market is a little bit ahead of reality. The economic statistics have decelerated and they are showing signs of cresting but they're not at a point, other than housing, that would signal, in our opinion, a dangerous level of economic growth that would justify a cut in rates. It reminds us a little bit more of the late '80s than 1995, which has been the year that has been oft quoted-that 2006 would be a repeat of 1995, whereby the Fed finished raising interest rates-it was a soft landing, equities were up 30%, bond yield were down 2%, etc. We think there will be a bit of a pause, and then after that you see how this feedback loop mechanism responds, and if the economy reaccelerates even slightly then the need for interest rate cuts will be mitigated. It is [conceivable] that rates could rise in early 2007 if you get a strong Christmas and a reacceleration of some of these economic statistics.

Landmann: We are pretty closely in agreement with that outlook. We think the Fed is definitely on hold and we are not going to see rate cuts any time in the near future. The posture toward risk is very cavalier right now. Particularly, it has been in the housing market where speculative excesses have been built up to sort of a crescendo. One of the things that Greenspan was heavily criticized for was, quote "the Greenspan put." That is whenever our market got into trouble, Greenspan was there to bail out the speculators. It led to sort of an asymmetric response mechanism on the part of the markets. Our belief is that Bernanke is very aware of that and that he does not want to be in there bailing out the speculators in the housing market at the first sign of trouble. Obviously, if the housing market crashes very hard, and we get into mid-2007 and there is a lot of feedback between the housing market crash and other areas of the economy, you could see the Fed ease at that point.

Healey: Originally our forecast at the beginning of this year was that the Fed would have to go towards 6% on Fed funds, now obviously what changed was the reaction when we had a change in CPI, and it was just a minor change in CPI that started all that. Bernanke basically has a dual mandate, but he's not worried about inflation because he's a forecaster and he thinks that eventually it will go down. There's still that possibility that he is wrong on his forecast and that you do get the recovery, and given where he has set his target or comfort zone on inflation, core inflation at 2%, being at 2.5% now, the Fed, we feel would have to be forced to do the "credibility trade," which would be to raise rates. So, it's kind a bi-modal trade here. There's talk about 1995, which is kind of that Goldilocks economy, that soft landing. Soft landings happen once in a blue moon, and I think for people to think that the Feds' going to engineer another soft landing doesn't make sense. When the Fed goes, they go a lot.  I just don't see three rate cuts, I think that if it came to that, it would be a lot more.

Simonoff: As long as we've got you, let's go back to the future. What is the probability in your mind, Dan, of a recession in 2007/2008? If yes, will it be a severe or a mild one?

Fuss: My guess is that I don't think we will have one. But each time you get in a situation like this, like it or not, you have to extend and move the bond fund duration from 4.1 to 7.2. Jay's point, as you dig into the possibility of deflation, could this be Japan 15, 16 years ago? Yes, it could. There are a number of things that could cause that, the most severe being an unwinding of the extra liquidity the wrong way. So, it could happen. The reason we don't think that is a high probability-in terms of real GDP, a slowdown to 2% and then 1.5%-is because so many parts of the economy in fact are fairly strong. We never have had the employment growth that you would have gotten, say, in the '80s and '90s. The best comparison I can give in terms of history-and it is only about a 20% to 25% overlay but it's instructive-is the 1960s, and it gets very confusing when you have a situation where your underlying pressures are in fact inflation.
    Number two, the population dynamics have changed radically. They are not at all like the '60s, by the way, in such a way that it's the revenue collection. Look at the U.S. Treasury borrowing requirement. It is a function of the deficit, which in turn is a function between how much of GNP do you take in and how much do you spend. That's the key point. It looks like here we have had a wonderful, tremendous economy for a number of years, and none of my statements should be taken politically. I am a political agnostic.
    My guess is that until after the 2008 presidential elections you are not going to get an increase in taxes. You get a modest increase right now, but it is not an increase in the rate. Nor are you going to get a decline in spending. At the increment, and I hope I am wrong on this, more and more of your gross national activity is going to the war. The war includes people checking your bags at an airport. Our guess is that the Treasury borrowing rule/requirement is going to start to rise at an exponential rate. The cost of the debt, because of the rise in interest rates and the increase in spending, starts to accelerate, very much like the '60s. If that happens, your incremental borrower is the Treasury, which compresses your spreads. Capital spending holds back as the rate goes up. You get into a stagflation environment. I hope I am wrong. I pray I am wrong.

Simonoff: Jay. What's your probability-recession in the next 24 months or so?

Chitnis: In terms of 24 months, 2007 is not likely, and I'll tell you one of the reasons why is because everybody talks about housing. Housing imploding, housing crashing, etc. I am one of the few and perhaps the only manager here that manages bond funds and an equity fund, and we have noticed that the homebuilders' stocks are up, up, 20% in the last couple of months. The stock market, we have found, is a pretty good indicator of those kinds of inflection points, where homebuilder shares were down 50% from peak and they are now up 20%. So, if the housing market stabilizes, then the entire talk of recession is completely unwarranted in our opinion; 2007, we think the probability of a recession is low. On the contrary the feedback loop, if the feedback loop really works as we think it will, then growth may reaccelerate closer to the 3% level.
    2008 is also interesting because there is an Olympics happening half-way around the world, in Beijing.  It is our opinion that China will be a locomotive into 2008, so a global recession is a low probability going out into 2008. Now, once everybody leaves the Olympics in August of 2008, our question is, who is going to buy all the steel in the plants that China is building? Who is going to buy all those extra sneakers that they built the factories to produce? That's where we get into our recessionary and quasi-deflationary environment.
    So it is beyond 2008 that we feel the probability of a recession starts to spike up a little bit. We will also get to a point where if we have 24 more months of growth in the U.S. it starts constraining supply over here, leading interest rates potentially higher. As you go out closer to the 24 months the probability increases, but we still don't think it's greater than 50%.

Simonoff: Laird, you are from California-they never have recessions, do they?

Landmann: Being from California, we have a slightly different take on the housing market than Jay. We do see considerable vulnerability there. It is not just the homebuilders that will affect the economy overall, it's the people in the margins who bought too much house, who got caught speculating in the housing market. Those are the people who are going to be leading our slowdown in 2007 that we are calling for. We are not calling for a recession either in 2007, and 2008 I think is too far out in the spectrum.
    Something like 40% of all adjustable rate mortgages will reset upwards coming into 2008 from where we are today. That is going to have a tremendous drain on household incomes. We are not quite as macro-oriented as some of the other panelists. We look at what the microtrends are going on in the economy, and we certainly think there is going to be a lot of trouble in the asset-backed securities market by the time we get to 2008. I think that people have been very cavalier about the type of credit risk. People buying triple-B, asset-backed securities that are 150 basis points over the London Interbank rate are going to pay for those risks down the road.
    Those are the types of things that will most likely produce a slowdown, in our opinion, in 2007 and 2008. Whether that will turn into a recession really just depends on whether you can engineer a soft landing in the housing market. We don't think so. We agree with Bill that soft landings are a blue moon type of event, and most likely virtuous cycles become vicious cycles at some point. Maybe we are biased, but we see substantial downturns in those valuations that by 2008 could put us at risk for a recession.
Simonoff: Mention a soft landing in the housing market and Bill is shaking his head. Do you think that could be the tipping point?