via Calculated Risk: Economist Tucker Hart Adams: Recession Imminent: "The economy stands at a fork in the road as we move through 2006, and we can make an equally compelling case for a year that ends in recession for the nation and most of the industrialized world. If the Chinese economy crashes, if Asian central governments stop buying U.S. government securities and interest rates move up 150-200 basis points, if there is an outbreak of trade protectionism in the U.S. that spreads around the globe, if the housing bubble bursts, if U.S. debt and deficits – consumer, government and/or current account – become unmanageable, if oil prices continue to rise – any combination of these and perhaps no more than a single one makes a recession inevitable. In terms of a mild recession, it is only a question of when it occurs, in 2006 or a year or so later. At some point U.S. consumers must bring their debt under control and housing prices must reflect demand for living space rather than Ponzischeme speculation. At worst, the eerie parallels with 1929 turn out to be predictive and we face a long period of difficult economic times."
The best analogy I can think of is driving on ice: the car begins to slide; the right thing to do is to steer with the slide, in the hope that you will regain control as the car resumes normal forward motion; the natural impulse is steer away from the slide, but unfortunately, that natural impulse will ensure that you lose control and the car will spin. Right now, the Federal Reserve appears to be in control. I say, appears to be in control, because the Federal Reserve is deliberately and periodically raising the Federal Funds Rate, with the announced intention of heading off inflation. That's the Federal Reserve's normal function, steering the economy away from inflation. But, there are icy patches on the road ahead. Any number of factors -- a spike in oil prices stands out -- might cause the Federal Reserve to overreact, to tighten hard, when it should be accomodating.
The Federal Funds Rate is the shortest of short-term interest rates. Long-term rates have remained mysteriously low for some time, helping to drive a housing bubble, which has affected many local housing markets in much of the English-speaking world.
I suppose the worst case scenario is the Fed responding to an apparent uptick in inflation, driven by higher oil prices, with higher interest rates. Higher long-term rates depress the go-go housing markets, which ends the boom in construction, causing a recession. Oil prices have only spiked, and they fall suddenly -- there is no inflationary pressure, but interest rates are higher anyway; a wave of bankruptcies, which start with a decline in housing prices, scare people into a sudden shift toward saving. Consumer demand collapses, and the recession is sharp and deep. The decline in consumer demand scares business, which limits investment, which further deepens the recession. China decides to allow its currency to rise relative to the dollar, which raises prices at Wal-Mart, further scaring consumers. China allowing its currency to rise, though, also means that interest rates have to remain high, choking off early recovery.