U.S. Economic and Interest Rate Outlook
Jan.16, 2001
Dancing With The One That Brung You - 2001 Recession Not Forecast
ntrs.com
ntrs.com
We must be natural-born contrarians, because we are not forecasting an official recession for 2001. Back in the early spring of 2000, when the economy seemed as though it would never cool, we were calling for a cooling off. Now that business activity has moderated to the point that it looks as though the economy might slip into a recession, we think the odds favor skirting one. Admittedly, it might feel like a recession in the first half of this year with economic growth forecast to average only about 1½%. But by the second half, we estimate that economic growth will have picked up to about 3¼%. Furthermore, we do not believe that the Fed needs to drop the funds rate nearly as much as is currently priced into the market - which is about 100 basis points by midyear - for this outcome to occur.
Why are we so uncharacteristically upbeat when so many others in the economics profession(?) seem to have a case of the blues? After all, haven't we been warning of a potentially destructive private sector debt time bomb ticking out there? Haven't we written about the prospects for a sharp drop in consumer spending when households would have to resort to "old era" ways to build up there net worth - actually saving some of their income - after the stock market quit generating stupendous capital gains? Well, these very ominous factors still exist. But we just think that Alan Greenspan, like Mighty Mouse, will save the day as he already has cranked up the monetary printing presses. We also believe, however, that this might be the last time that Mighty Alan will have the printing press option at his disposal. Why? Because later this year investors will not believe him when he asserts that "inflation pressures remain contained."
For the same reason that back in the spring of last year we were forecasting a significant slowdown in economic growth in the latter part of 2000 we are now forecasting the avoidance of an official recession. And that reason is? The behavior of the real M2 money supply. As of November, the year-over-year change in real M2 was 2.9%. Chart 1 below shows that since the real M2 series began, in 1959, the US economy has never entered a recession with real M2 growth this high. Moreover, as shown in Chart 2, nominal M2 growth has re-accelerated in recent weeks. The FOMC's 50 basis point cut in the fed funds rate on January 3 and the additional 50 basis points of cuts we are forecasting to occur by close-of-business March 20 would be expected to boost nominal M2 growth still more.
Chart 1
Source: The Conference Board/Haver Analytics
Chart 2
Source: Federal Reserve Board/Haver Analytics
We've been at this game long enough to know that it is dangerous to put all of your forecasting eggs in one basket. So, we have been keeping tabs on another of our favorite recession warning signals - the yield spread between bonds and the fed funds rate. Along with real M2, the yield spread between 10-year US government bonds and fed funds is a component of the Index of Economic Leading Indicators. Typically when heading into a recession, this particular spread goes negative. In December, this spread was a negative 116 basis points, and has been consistently negative since June. Based on its historical record as shown in Chart 3, this spread clearly is signaling a recession.
Chart 3
Source: Federal Reserve Board/Haver Analytics
But we know that the Treasury securities market has been affected by an unusual supply-demand dynamic in 2000 - the paydown of marketable debt and the prospect of much more to come. Could it be that this dynamic has distorted the spread recession signal by depressing Treasury yields? If so, is there an alternative yield spread we could use instead? As shown in Chart 4, the yield spread between Moody's Aaa corporate bonds and fed funds appears to track the Treasury - fed funds yield spread pretty well, as evidenced by the 0.97 correlation coefficient between the two.
Chart 4
In December, the yield spread between Aaa corporate bonds and fed funds was 81 basis points. This magnitude of the spread is above that which has ever signaled a recession in the past 46 years. Moreover, as shown in Chart 5, this yield spread widened out to 117 basis points after the FOMC cut the funds rate by 50 basis points on January 3. As is the case with real M2, this yield spread is not heralding a recession. Although it would be easy for us to conjure up a recession forecast, out of loyalty to real M2 and the yield spread, the ones that brung us to this dance, so to speak, we will continue to follow their lead. And right now, they are leading us away from a recession forecast.
Chart 5
We expect that the first quarter will be the weakest one of the year in terms of economic growth. Inventories will be a big drag on growth, especially with motor vehicle producers cutting production in order to get stocks better aligned with sales. The weather also is likely to reduce first quarter expenditures. Given three consecutive milder-than-normal winters, seasonal adjustment factors are "expecting" another milder-than-normal one. In reality though, this winter is shaping up to be normal, if not harsher than normal. Thus, construction, production and consumption data in the first quarter could be biased downward by the weather. This may already have started with some December economic reports. Assuming more normal weather in the spring, the "temperature" of the economic data should warm.
As mentioned above, we expect that the Fed will cut the funds rate another 50 basis points in total by the adjournment of the March 20 FOMC meeting. This, along with the January 3 cut of 50 basis points, ought to provide a fair amount of monetary policy stimulus to the economy in the second half of this year. Discretionary federal spending is scheduled to pick up in fiscal year 2001 and it looks as though some federal tax cuts could become effective by midyear. Assuming that the FOMC does not raise the funds rate in 2001, which we do, these increased federal outlays and tax cuts will be "monetized" by the Fed. This, too, will stimulate domestic aggregate demand in the second half of the year.
One of the justifications the FOMC gave for its January 3 rate cut was "high energy prices sapping household and business spending power." In other words, the Fed thinks that the rise in energy prices in the past two years is a kind of negative shock to the aggregate demand for goods and services. We view it differently. We believe that the rise in energy prices represents a negative shock to the aggregate supply of goods and services. There is a shortage of natural gas in this country. This shortage is constraining how fast the economy can grow. A more accommodative monetary policy stimulates aggregate demand, not aggregate supply. Thus, by the Fed printing more money in the face of energy constraints on the economy's growth rate, the tradeoff between real economic growth and inflation is likely to worsen. That is, the prospects for stagflation are increasing.
It is not clear that rising energy prices "saps" aggregate demand. The monies from those higher gasoline and utilities bills you pay don't disappear. Rather, they go to those involved in the production and distribution of energy. These recipients then spend these monies to find more energy and to augment the energy distribution system. So, an increase in energy-related investment expenditures will provide an offset to the decline in non-energy-related expenditures.
Because productivity growth tends to be highly procyclical, the slowdown in economic growth that we are experiencing will also be associated with a slowdown in productivity growth. This already showed up in the third quarter data in which productivity growth slowed to 3.3% from 6.1% in the second quarter. Another factor that will slow productivity growth is the coming slowdown in high-tech production. The data clearly show that the bulk of the recent years' increased productivity growth has come from the production of high-tech equipment itself. With the rising unemployment rate this year - we look for it to move up to 4.5% by midyear - labor compensation growth will moderate. But if history is any guide, the slowdown in productivity growth will be more than the slowdown in labor compensation growth. Thus, unit labor cost growth, which picked up in the third quarter, will continue to do so as we move through this year. Corporate profits are likely to bear the brunt of higher unit labor costs. But somewhat higher inflation will result, too.
Economists have been predicting a decline in the foreign exchange value of the US dollar for years now. 2001 might just be the year in which this prediction proves correct. The bloom is off the US stock market and US corporate profit growth. Moreover, for the first time in years, European economic growth is expected to outpace that of the US. Thus, the environment is ripe for capital to start migrating away from America. A decline in the dollar would add another ingredient to higher inflation.
What we are getting at here is that we see the potential for further advances in "core" inflation in the second half of 2001 and into 2002. Although the Fed is likely to be pre-occupied with preventing a recession early this year, it might have to turn its attention to "containing" inflation early next year. As discussed above, we do not believe that the Fed needs to cut the funds rate by more than another 50 basis points to move the economy safely away from a recessionary abyss. If we are correct about 50 basis points more doing the trick and about core inflation becoming more of an irritant as the year wears on, then it is likely that interest rates outside of the money market area have already put in their lows for the year. If the Fed does cut the funds rate aggressively in the first half of this year under the cover of moderating "headline" inflation, then it may be faced with a policy reversal before 2001 is over.
As mentioned above, we could easily come up with a recession scenario, or even worse. With corporate profit growth slowing and corporations leveraged up to their eyeballs, the potential for a collapse in capital spending exists. With household debt payments getting onerous and with households actually dis-saving I recent months, the potential for a sharp pullback in consumer spending exists. But we feel that these events can be postponed so long as the Fed has the policy latitude to print more money, which it apparently does right now. The day of reckoning will come, however, when the higher inflation resulting from the printing of money no longer gives the Fed the option of printing still more. As Cubs fans say, "Wait till next year!"
Paul Kasriel
Head of Economic Research
Asha G. Bangalore
Economist |
