General Economic Outlook Recession! Will it be Short and Shallow? Larry DeBoer January 2002 We re in a recession. The National Bureau of Economic Research (NBER), the quasiofficial arbiter of business cycle dates, marked the end of the long 1990s expansion in as of March, 2001. It was a close call, they said. September 11 decided the matter. Real GDP grew hardly at all in the second quarter, and fell at a 1.3% annual rate in the third quarter. The unemployment rate has increased from its late-2000 low of 3.9% to 5.7% as of November. Just since August the unemployment rate has risen eight-tenths of a point, which implies that real GDP probably fell again in the fourth quarter. When will the recession end, and what will end it? Housing construction is the economy s one clear strength. Residential construction has hardly been affected by the recession, and a high level of building permits and low mortgage interest rates point to continued growth in this sector. Inventories of goods accumulated in the beginning of the year, depressing employment and output. Now excess inventories have been sold, and this should encourage firms to increase output. Consumer expectations were turning toward optimism prior to September 11. Since September s big decline, expectations have edged upward again. It may take until midyear, but consumers will probably increase their spending in response to low interest rates, further tax cuts, rising stock values, and falling inflation rates. The Federal Government will run a budget deficit this year, for the first time since 1997. In the midst of a recession, this is welcome. Equipment investment presents a problem. The industrial capacity utilization rate is at a 17-year low, and equipment orders have fallen a lot in the past year and a half. It is unlikely that equipment investment will resume the rapid growth of the 1990s. The rest of the world is also experiencing recession, so exports are unlikely to grow much. Expect declines in GDP for the fourth quarter 2001 (when the reports come in), and the first quarter of 2002. Overall, expect GDP to grow 1% above inflation over the next year. With such slow growth, the unemployment rate is likely to rise to 6.5% by this time next year, while the inflation rate should hold at about 2%. The Fed has probably reached the end of its expansionary policy drive there s not much more room for rate cuts. Expect the short term Treasury interest rate to be about 1.5%, and the long term rate 4.5%, by this time next year. And, sometime in the Fall of 2002, expect the NBER to mark the recession s trough in March. By this time next year, the new expansion should be ten months old.
January Forecast GDP Unemp- Int. Rate Int. Rate Forecast Growth Inflation loyment 3 mo. T 30 yr T Jan '02 1.0% 2.0% 6.5% 1.5% 4.5% Jan '01 3.0% 3.0% 4.5% 5.0% 5.3% Actual 0.5% 1.9% 5.7% 1.9% 5.1% Diff. 2.5% 1.1% -1.2% 3.1% 0.2% Aug '01 3.5% 3.0% 4.0% 6.2% 6.4% Oct 01 1.0% 2.0% 6.5% 1.5% 4.5% It s Official: We re in a Recession We d been agonizing for months about whether we were in a recession or not. But in November, 2001, the National Bureau of Economic Research (NBER) declared that, not only is this a recession, but it started last March! The NBER has established itself as the quasi-official arbiter of recession and expansion dates they ve dated the business cycle all the way back to the 1850s. Marking the end of the 1990s expansion in March means that expansion lasted exactly ten years 120 months the longest expansion in U.S. history. Since World War II, the average recession has lasted 11 months from peak to trough. Maybe that s a silver lining in our dismal economic situation. If this recession is average, the trough will be in February 2002. Gross Domestic Product (GDP) has grown only 0.5% above inflation over the past four quarters. Quite a comedown from the 4.1% average over the preceding three years. Worse, the third quarter, 2001, showed real output falling by 1.3%. The rise in the
unemployment rate during the fourth quarter indicates another drop of between one and two percentage points. HowLong? The recession should end during the first half of 2002. Next Fall, the NBER will probably mark the end of the recession in (say) March 2002. Leading Indicators. The leading indicators now point away from recession. The Conference Board s index of leading indicators almost (but not quite) indicated a recession in December 2000. It had fallen 3% over the previous six months. As of November, though, the index was almost one percent higher than it had been six months before. This is an indication of expansion ahead. The spread between long and short term Treasury security yields is usually a reliable leading indicator. Sure enough, between August and December 2000 the yield curve inverted, meaning the short term rate was higher than the long term rate. This usually indicates an increased probability of recession within a year. In January, however, the yield curve righted itself, and in November long term rates were two and three-quarter points higher than short term rates. This says that the probability of recession continuing through the next year is just about zero.
Consumption. In previous expansions, consumer spending growth usually slowed as the expansion continued. Not so the expansion of the 1990s. Consumer spending grew faster between 1997 and 2000 than it did in the first half of the decade. Durable goods spending grew especially rapidly, average 10.5% per year above inflation. In the past year spending on all categories of consumer goods and services has slowed; in the third quarter the slowdown was even more pronounced. Consumer spending is still growing in real terms, but only about one percent per year. Recent GDP Growth Prior Past Past Major GDP Components 3-years year Quarter G: Federal Defense -0.5% 5.9% 3.2% C: Durable Goods 10.5% 4.0% 0.9% I: Residential Structures 4.6% 3.9% 2.3% G: State and Local 3.3% 3.5% -1.3% C: Services 3.9% 2.8% 1.2% C: Non-durable Goods 4.5% 1.0% 0.6% GDP: Gross Domestic Product 4.1% 0.5% -1.3% I: Business Structures 3.8% -0.5% -7.6% G: Federal Non-defense 2.4% -1.1% 4.2% M: Imports 11.8% -6.8% -13.0% I: Business Equipment 11.8% -7.5% -8.8% X: Exports 4.9% -9.2% -18.8%
Until September 11, the outlook for consumers was upbeat. The University of Michigan s Index of Consumer Expectations is a leading indicator of consumer spending. It had fallen a lot in December 2000, and in January and February 2001, but it rose from March through August. In September the index dropped 14%. In October and November the index has risen, a little. Business orders for consumer goods haven t risen yet either, after falling since May 2000. At the moment there is not much sign of a resumption of consumer spending growth. Since consumers are so important in the economy, this probably means decline or slow growth for GDP for the first half of next year. After that, though, consumers should increase spending growth. The reasons will be low interest rates, declining inflation, more tax cuts, and rising (or at least not falling) stock values. Further, by then consumers will have seen slow spending growth for more than a year. Many will be anxious to replace durable goods that have worn out. Investment. Housing construction is the economy s bright spot. In past recessions housing construction declined a lot it fell 26% from high point to low point during the last recession. But this time, the growth in housing investment was only a little lower in 2001 than it was during the last years of the 1990s. The third quarter of 2001 saw the highest real spending on residential construction, ever. Residential building permits are a leading indicator of housing construction. They are down from their 1998-99 highs, but remain above any level seen prior to 1998 they give no sign of a coming collapse in housing construction. Low mortgage interest rates are probably the reason for continued housing investment, the fruits of the Federal Reserves aggressive interest rate cuts. Mortgage rates remained well below 7% in November. Housing investment should continue to grow. Equipment investment is the other side of the coin. In the three years up to mid-2000, equipment investment grew an average of 11.8% per year. As a result, we now appear to have all the equipment we need for the coming year. Equipment investment is unlikely to grow much, and may continue its decline. It fell 7.5% in real terms over the past year. An ominous sign of the glut of equipment is the capacity utilization rate, a kind of reverse unemployment rate for factories and machinery. Utilization peaked in June 2000, and has fallen without pause since. As of November 2001, it is at its lowest level since 1983. A leading indicator of equipment investment is manufacturer s non-defense capital goods orders. This indicator reached record highs in mid-2000, but as of October had fallen 35%. It is up a bit in November. It appears that industry has the equipment it needs to meet demand for goods for some time to come. A revival of equipment investment seems unlikely. The GDP figures include inventories as a form of investment. Inventories appear to have played an important role in our current recession. The ratio of inventories to sales rose between June and November 2000. Demand for goods was less than businesses expected. The accumulation of inventories helped cause the cut in production and employment starting in 2001. In past recessions, the inventory sales ratio has fallen before the recession ended. Businesses sell off their excess inventories, and only then
increase output. The ratio began falling in July. Excess inventories are being sold, so we may expect inventory investment to increase in 2002. Trade. The trade deficit usually shrinks during U.S. recessions. In 1990-91, exports grew while imports fell. This year, imports have fallen, but exports have fallen more. The trade deficit got bigger. According to the GDP accounts, imports exceeded exports by an amount equivalent to one percent of GDP in the mid-1990s. In 2001 the deficit was about four and a half percent of GDP. Slower U.S. income growth is reducing U.S. imports. But the rest of the world is also seeing slower growth. The value of the dollar has not changed much over the past year against the currencies of our major trading partners. It s up by about a third since 1995. That makes our exports more expensive, and our imports cheaper, and is probably playing a role in our big trade deficit. The value of the dollar may fall in the coming year. The trade deficit and low U.S. interest rates point that way. But the U.S. is still the world s safe haven, and with the rest of the world in difficulty, the U.S. may still be the best place to keep wealth. The dollar s value probably will not fall enough to affect exports much in the next year. The outlook for the rest of the world s economies is not very bright, so exports will likely continue to be a drag on growth. A currency crisis that develops into an international panic like 1997-98 is an unpredictable wildcard in any economic forecast. Outlook. Overall, expect Gross Domestic Product to grow about 1% above inflation over the next year. Most of the growth will occur in the second half of the year. The fourth quarter of 2001 and first quarter of 2002 will likely see declines. Housing investment is the clear positive for the next year. Excess inventories should be sold off soon, encouraging business to increase production. Consumers are likely to resume spending by mid-year. Expectations were rising before September 11, and have edged up since that shock. Low interest rates should help consumption and investment spending. Our old friend, the federal budget deficit, will reappear this year, and in the midst of a recession it is welcome. Expect no boom, however. Exports will lag, with slow growth in the rest of the world. State and local governments will have to face the budgetary music this year, with spending cuts and tax hikes. Most problematic is equipment investment. Industry has more excess capacity now than at any time since the early 1980s, and orders for equipment have fallen a lot in the past year and a half. Policy Monetary Policy. Since the beginning of the year the Federal Reserve has cut interest rates eleven times, a total of four and three-quarters percentage points. This is aggressive expansionary monetary policy. It seems likely that the Fed has about finished with its rate cutting, however. For one thing, it is said to take six to nine months for Fed policies to be effective. That would mean most of the effect of these rate cuts are still to come. The Fed may think it time to
wait and see what effect its policy has had. For another, there simply isn t much room left to cut rates. The federal funds rate is now at 1.75%. It can only go to zero. Fiscal Policy. The mid-2001 tax cut was well-timed. $38 billion in tax refunds arrived in mailboxes in late summer, in what we now know was the middle of the recession. Unfortunately, consumers did not respond as hoped. One survey taken in the Fall found that only 22% of households had spent or intended to spend their rebates. Any first year economics student can tell you that a marginal propensity to consume as low as that will produce a very small multiplier effect. The first tax cut appears to have failed. Congress and the President were unable to agree on a stimulus package of further tax cuts and spending hikes. But the Federal budget will be a source of stimulus for the economy in the coming year, anyway. Tax revenues will drop with declining incomes and with the scheduled tax cuts; spending will rise with the added military expenditures. Just a year ago we wondered what the world would be like if the Federal Government ran budget surpluses as far as the eye could see. Now we know that fiscal 2002 will see a budget deficit, and there is no danger of paying off the national debt anytime soon. State and local governments can t run budget deficits. Many were taken by surprise by the recession in 2001. They will react with their budgets in 2002. Expect tax hikes and spending cuts from the state and local sector. We may see another quarter point cut or two from the Fed in the coming year, but the guess here is that aggressive expansionary policy is done. Expect the three month Treasury security interest rate to be around 1.5% by this time next year, and the long term rate around 4.5%. Inflation and Unemployment Inflation. Not counting food and energy, the inflation rate has been very stable these past years. Since 1997 the 12-month inflation rate had ranged from 1.9% to 2.8%. Since mid-
1999 it has trended upward about three-quarters of a point, to its current 2.8%. The overall inflation rate, including all consumer items, has been less stable. The range since 1997 has been between 1.4% and 3.8%. It s at 1.9% now. The difference, of course, is energy. Energy prices fell radically in 1998, and rose radically in 1999 and 2000, and fell a lot in 2001. Now they re edging upward again, and the OPEC decision to cut production may mean somewhat higher energy prices in coming months. Recessions usually bring down inflation rates, but energy prices are tough to predict. The inflation rate less food and energy should fall a bit in the next year, to 2%, and the overall inflation rate should bounce around this rate. Expect inflation to be 2% over the next twelve months. Unemployment. The unemployment rate reached a 30-year low of 3.9% in October 2000. It edged up to 4.5% as of July, but since then has risen substantially. In November the rate was 5.7%. Unemployment will go up some more. The rule of thumb is that real GDP must grow about 3% per year to keep the unemployment rate stable. Slower growth results in increases. If GDP only grows 1% over the next year, expect the unemployment rate to rise to 6.5% by this time next year.
Macroeconomic Forecasts for 2002 on the Internet Forecast & Date GDP Inflation Unemp- Int. Rate Int. Rate Growth (CPI) loyment 3-mo. T 10-yr. T Congressional 1.7% 2.7% 5.2% 3.8% 5.6% Budget Office 8/28/01 http://www.cbo.gov RSQE 0.7% 1.8% 6.4% 1.7% 4.8% U.Michigan 12/12/01 http://rsqe.econ.lsa.umich.edu Survey of Professional 0.8% 2.2% 6.0% 2.3% 4.6% Forecasters Philadelphia Fed 11/20/01 http://www.phil.frb.org/econ/spf/ KEY: 3-mo. T: Three month Treasury note 10-yr. T: Ten year Treasury bond CPI: Consumer Price Index RSQE: Research Seminar in Quantitative Economics
AVERAGE FORECAST ERRORS 20 SEMI-ANNUAL FORECASTS SINCE 1991 GDP Unemp- Int. Rate Int. Rate Growth Inflation loyment 3 mo. T 30 yr T Mean Error -0.7% 0.3% 0.2% 0.4% 0.3% Mean Absolute Error 1.2% 0.6% 0.6% 0.5% 0.4% Mean error shows the average of the differences between forecasts and actuals. A big positive error and an equally big negative error would sum to a zero average. Over 20 forecasts, on average I underpredict growth by 0.7 points. Mean Absolute Error shows the average of the absolute differences between forecasts and actuals. Over 20 forecasts, on average I miss GDP growth by plus or minus 1.2 points.