Red Skies at Night, Sailors' Delight Red Skies in the Morning, Sailors Take Warning

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1 Red Skies at Night, Sailors' Delight Red Skies in the Morning, Sailors Take Warning by Edward Leamer Director UCLA Anderson Forecast March 2005 We had a great year in 2004 with GDP up almost 4% and employment up 1.6%. Red Skies at Night. That was last year. Next year is sure to be different. Lurking somewhere out there is another economic recession with GDP and employment both declining. You need to worry about that possibility. A recession isn t going to happen in 2005, but is quite likely to occur by the end of the decade. Will you be ready? Red Skies in the Morning. To see what is likely to happen the rest of the decade we are going to have to look farther backward than just last year. Figure 1 is a bar chart of the growth of US GDP with the recessions in gray. Take special note of the fact that the downturn we experienced in 2001 was so mild that it hardly counts. 1 It was also unusual in that it involved no decline in consumer spending. What comes after an unusual recession is likely to be unusual as well, a point on which we have been harping for three years now. Figure 1 US GDP Growth Official NBER Recessions in Gray Kennedy/Johnson Reagan Bush/Clinton UCLA Anderson Forecast, March 2005 Nation-1.1

2 Table 1 Ten Expansions Since WWII "Official" NBER Length GDP Increase Trough Peak Quarters Total 12 Quarters Average 1 Truman 1949 Q Q % 25.4% 8.2% 2 Eisenhower I 1954 Q Q % 12.2% 4.1% 3 Eisenhower II 1958 Q Q % 6.1% 4 Kennedy/Johnson 1961 Q Q % 18.4% 5.9% 5 Nixon 1970 Q Q % 16.3% 5.4% 6 Ford/Carter 1975 Q Q % 14.0% 4.6% 7 Carter/Reagan 1980 Q Q % 4.4% 8 Reagan 1982 Q Q % 18.5% 4.8% 9 Bush/Clinton 1991 Q Q % 9.6% 4.0% 10 Bush/? 2001 Q4??? % 10.9% 3.6% Expansions Have Not Lasted Very Long Another notable aspect of Figure 1 is that the expansions between the recessions have not been all that long. The economic expansion that we are currently enjoying officially began in 2002 Q1, and is now thirteen quarters old. That s mature by historical standards. Five of the last nine expansions have terminated at 14 quarters or less. Only three have lived more than 20 quarters. The details are shown in Table 1. If you are like me, and prefer pictures to numbers, this same information is conveyed in Figure 2, which shows how GDP has behaved over the ten expansions, with a side-by-side comparison. The horizontal axis is the age of the expansion and the vertical measures the cumulated growth of real GDP. Here you can see the three long expansions, and you can see that the Bush expansion that we are currently enjoying is reaching the probable time of death, by historical standards. You can also see that the Bush expansion is off to a slow start, about the same as the Bush/Clinton expansion of the 1990s. The numbers are in Table 1. After 12 quarters, GDP has grown by 10.9% this time, compared with 9.6% for the Bush/ Clinton expansion, both of which are considerably less than the growth in the first 12 quarters ranging from 12.2% to 25.4% in the earlier expansions. The record length of 40 quarters was set by the Bush/Clinton expansion in the 1990s. Should we expect a repeat? Will there be another Bush/Clinton expansion. That would require two improbable events: This expansion would have to last another four more years and Hillary would have to be elected. You make your own judgment on Hillary. I want to tell you that it is unlikely this expansion will last through George W s second term. The Three Long Expansions Had Growth Spurts That Extended Their Lives The three longest expansions all experienced growth spurts during which the rate of growth of GDP Nation -1.2 UCLA Anderson Forecast, March 2005

3 Figure 2 Ten Expansions Real GDP During Economic Expansions, dated by NBER 60% 50% 40% 30% 20% Truman Ford/Carter Kennedy/Johnson Reagan Bush/Clinton 1949 Q Q Q Q Q Q Q3 10% 0% Bush W 1982 Q Q Q3-10% Figure 3 Unemployment Rate in 10 Expansions Unemployment Rate Compared with Rate Six Quarters Before the Expansion Begins Change in Unemployment Rate Age of Expansion in Quarters Growth Spurts Growth Spurt 1949 Q Q Q Q Q Q Q Q Q Q4 was abnormally high and the rate of unemployment was driven down. The path of unemployment during the 10 expansions is illustrated in Figure 3. Here you can see the rising unemployment during the recession in the quarter before the expansion begins. The unemployment rate continues to rise early in the recovery but then is driven down to approximately its level prior to the onset of the recession, at which point the unemployment rate levels off as economic growth returns to normal levels. Most of these expansions UCLA Anderson Forecast, March 2005 Nation-1.3

4 terminate with that level of unemployment. But the Kennedy/Johnson expansion and the Reagan expansion had a growth spurt commencing about the 14 th quarter that drove down unemployment. The Bush/ Clinton expansion had its spurt commencing at about 24 quarters. Figure 4 has the data on GDP growth smoothed so you can see the spurts in the long expansions. Each Spurt Has Its Own Logic The Kennedy/Johnson expansion of the 1960s had two spurts. The first was driven by the Kennedy tax cut of 1964 that reduced the Federal Taxes as a share of GDP by 2% and the second was driven by spending by the Department of Defense for the Vietnam war that increased Federal spending as a Figure 4 US GDP Growth: Five Quarter Centered Average Official NBER Recessions in Gray Kennedy Tax Cut Vietnam War Low er Interest Rates, Falling Dollar, Cheaper Crude Oil Internet Rush Kennedy/Johnson Reagan Bush/Clinton Figure 5 Federal Revenue Federal Revenue : Fraction of GDP 21% 20% 19% 18% 17% 16% 15% 14% Nation -1.4 UCLA Anderson Forecast, March 2005

5 share of GDP by 2% in Call that the Fiscal Expansion. The Reagan expansion had a spurt in 1985 that driven by a cut in short-term interest rates from 10.3% in 1983 Q3 to 5.7% in 1988 Q1. That cut in interest rates stimulated an increase in the residential investment share of GDP from 3.9% to 4.7% and the consumer durables share of GDP from 7.8% to 9.0%. Coincident with the Fed s action was another monetary force: a sharply declining value of the dollar that help to increase exports from 7% of GDP to 9.5% of GDP. A fall in the price of crude oil also helped. Call that the Monetary Expansion. The Bush/Clinton expansion of the 1990s that was sputtering in 1995 had its life extended by the discovery of the Internet and the mad dash to the Web by business in search of illusory profit opportunities, a race that increased investment in equipment and software from 7.6% of GDP in 1995 to 9.4% in 2002 Q2. Call that the Animal Spirits Expansion. Can Fiscal Policy, Monetary Policy or Animal Spirits Create a Bush Growth Spurt? What could possibly extend the life of the Bush expansion of the 21 st Century? We would need some significant increase in spending. It won t come from a tax cut; we have already had that. We are at a very low point as far as Federal revenue is concerned, mounting deficits looming large in the future. And let s hope it won t be a ramp-up in wartime spending by an amount like the 2% of GDP figure of 1966/67 Vietnam War or the incredible 8% figure of the Korean war, illustrated in Figure 6. It also won t be a monetary stimulus. A monetary stimulus works through housing and consumer durables. The absence of any downturn on the consumer side during the 2001 recession, and the low interest rates for so long in the aftermath have stolen sales of homes and cars from the future, and it is highly unlikely that we can rely on those components Figure 6 Defense Defense Spending: Fraction of GDP 16% 14% 12% 10% Korea Vietnam 8% 6% 4% 2% UCLA Anderson Forecast, March 2005 Nation-1.5

6 Figure 7 Homes Investment in Residences: Fraction of GDP 8.0% 7.5% 7.0% 6.5% 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% Figure 8 Equipment and Software Investment in Equipment and Software: Fraction of GDP 10% 9% 8% 7% 6% 5% 4% Nation -1.6 UCLA Anderson Forecast, March 2005

7 of spending to drive the US economy anytime in the next several years. Take a look at Figure 7 that has the ratio of investment in residences divided by GDP. From the height at which we are standing today, there is only one way to go down. Think of it as a bathtub of consumer demand with a monetary drain. Open up the drain when the tub is full, and you get a large flow out. But open the drain when the tub has already been drained, and not much happens. Normally the bathtub fills up during the recession as consumers worry about jobs and choose not to buy homes or cars. This time the bathtub didn t fill up during the recession. On the contrary, it was draining at record rates. And thanks to the very low interest rates, we have been draining it rapidly ever since. There s not much left in there. So if not government and not the consumer that might extend the life of this expansion it must be business. It must be Animal Spirits. That is one way that this expansion will have a spurt that extends its life. It could happen. Some new idea might come from a Palo Alto garage that will compel businesses to invest like they did during the Internet Rush. It could happen, but it isn t very likely. We are already at a high level on that one. Exports A Ray of Hope? There is one small ray of hope exports. Exports were a major factor in the length of the Reagan expansion and could help this one as well. The declining value of the dollar relative to the Euro is sure to stimulate exports in the year ahead. Rising Interest Rates are the biggest threat to this expansion So that s it. This middle-aged expansion is going to the nursing home before it has a life-extending growth spurt unless something miraculous happens on Figure 9 Exports During 10 Expansions Exports : Fraction of GDP Bush/Clinton 12% 11% Bus h 10% Reagan 9% 8% 7% 6% 5% 4% Kennedy/Johnson 3% UCLA Anderson Forecast, March 2005 Nation-1.7

8 Figure 10 Interest Rates: 3-Month Treasuries 3-Month Treasury Bill Interest Rate 16.0 Interest Rate Figure 11 Interest Rates: 10-Year Bonds Interest Rate: 10 Year Treasuries Age of Expansion in Quarters Nation -1.8 UCLA Anderson Forecast, March 2005

9 the export side. The do-not-resuscitate notice was written when the Fed started raising short-term rates in June The notice hasn t been signed yet by the long-term bond markets, since long-term rates have come down a bit. But as Mr. Greenspan muses, that s a conundrum. Figure 10 reveals that although Mr. Greenspan has increased short-term rates dramatically he has a long way to go to get back to normal levels. You can also see in Figure 10 that rising rates were a feature of the ends of all these expansions. One of the best indicators of an oncoming recession is an inverted yield curve when the spread between the 10-year and the 3-month rate becomes negative. This spread is illustrated in Figure 11. Rising short term rates do not using come with falling long-term rates, but when it happens the slope of the yield curve flattens from both ends. That has given us a 200 basis point spread, which is pretty normal, but the direction in which this is heading is ominous. Forecast We can see a recession in the future, clear as day. We don t yet know when. Not this year. This year we are expecting trouble with housing in the second half that will make GDP growth a little weaker than normal, but it unlikely that a recession could get started that quickly without more telltale signs today. The recession could happen in 2006, but the economy moves either more slowly or more rapidly than most forecasters expect. Figure 12 Interest Spread: 10 Year Minus 3 Month Spread between 10 Year and 3 Month Interest Rates 500% 400% 300% 200% 100% 0% -100% -200% Endnotes 1 In addition, the problems began in 2000 you missed it, NBER. UCLA Anderson Forecast, March 2005 Nation-1.9