Federal Reserve bank of SF says investors out of their minds
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December 14, 2001
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Jack Beebe, Senior Vice President and Director of Research at the Federal Reserve Bank of San Francisco, states his views on the current economy and the outlook:
Following a sizeable decline in September, nonfarm payroll jobs fell sharply in October and November. Manufacturing employment continued to fall as it has done since 1998 and more rapidly since late 2000; recent monthly data have shown no turnaround in this pattern. But in October and November, employment declines spread well beyond the manufacturing sector. It is possible that recent data on initial claims for unemployment insurance are suggesting that the employment declines of December will be more modest than those of October and November.
The unemployment rate jumped further to 5.7% in November and is now almost 2 percentage points above its low in late 2000. The unemployment rate had risen surprisingly little in the first half of the year as employers held onto workers and as individuals dropped out of the labor force. But the rise in the unemployment rate during this recession is now looking more like what we had expected, and is very similar to that of the 1990-91 recession. On the basis of our growth forecast discussed later, we expect the unemployment rate to peak at around 6 1/4% by early 2003.
Capacity utilization in overall manufacturing continued to decline to 73% in November, while that in high tech fell to 60%. These data show the severity of the manufacturing recession which began well ahead of the March business cycle peak. There are now definite signs that sales in the semiconductor and computer sectors are beginning to pick up. However, in the communications equipment sector, we do not yet see signs of a bottom. Next year semiconductor and computer sales will pick up but sales of communications equipment could continue to languish into 2003.
The outlook for business fixed investment is mixed. Equipment and software investment, about half of which is related to high tech, turned down in 2000. In our forecast, we expect spending growth for equipment and software to turn positive by the middle of next year. Business structures investment, which is a very broad category encompassing all kinds of commercial buildings, structures for private education and hospitals, and construction for private utilities and mining, held up well into the early part of this year but is now declining very rapidly. We do not expect growth in this type of spending to turn positive until well into 2003.
Real spending on residential structures shows a very different story. This spending includes construction of all new homes and apartments as well as additions and alterations to existing homes. While recent data and those in our forecast bounce around quarter to quarter, there is no sign of a recession in this sector. This pattern is in sharp contrast to the deep recession that occurred in 1990-91 when spending on residential structures fell sharply for three consecutive quarters. Like consumer spending, spending on residential structures has been buoyed by declining interest rates and consumers' expectations that their permanent incomes will not be marred significantly by what is expected to be a mild recession. But like consumer spending, there are downside risks to residential investment if consumers become much more wary that their economic wealth might decline further.
Because of price cutting and zero financing incentives, consumer purchases of motor vehicles skyrocketed in October and November. However, December sales are beginning to sag, and sales in the first quarter of next year will depend critically on whether there are further price inducements. Recent fleet and rental car purchases have fallen off sharply, and bulging used car inventories are likely to cut into first quarter new motor vehicle sales.
Our forecast of consumer spending is stronger in the fourth quarter and then weaker in the first quarter because of variations in the level of auto purchases. The retail sector is expecting only modest Christmas spending with consumers directing their purchases toward "big box" outlets. In our forecast, consumer spending growth accelerates slowly in 2002 and more rapidly in 2003.
We are expecting near-term GDP growth to be negative in the fourth quarter and flat in the first quarter. Then we are expecting a relatively slow recovery beginning in the second quarter of next year. There are risks on both sides of this forecast. Stock and bond market activity over the past month or so suggests that financial players are expecting at least as much growth as we are forecasting, and perhaps more. There is at least a small possibility that the stimulus from monetary and fiscal policy (provided we get a fiscal package) will cause a burst of growth starting around the middle of next year. However, there's also a significant downside risk to this forecast. We are bound to see a string of poor earnings announcements for several more quarters as well as further layoffs and a rise in the unemployment rate. If consumers become more pessimistic in 2002, we could see significant declines in the stock prices, and consumer spending and residential investment would likely fall below the levels predicted in our forecast.
Despite November's surprise 0.4 percent rise in the core consumer price index, we are expecting inflation to edge down significantly over the next two years. Expectations of very tame price inflation, combined with slack in labor markets, suggest that labor cost inflation will recede almost a full percentage point over the next two years. Lower labor cost inflation, combined with a pickup in growth starting next year, suggests that unit labor costs will remain very tame. While firms will try to raise prices as markets strengthen, the continuation of general economic slack (as exemplified by the high unemployment rate and low capacity utilization in manufacturing) suggests that price inflation will decline over the two-year period. Our forecasts of core consumer price inflation are now about ½ percentage point lower in 2003 than we were forecasting 4-6 months ago.
After-tax corporate profits fell sharply again in the third quarter. Yet, special hits coming out of the September 11 attacks suggest that the fourth quarter profit rate may be a little above that of the third quarter. The picture for next year is that profits will lag in the recovery and the profit rate will be squeezed in most industries. Despite this possibility, analysts forecasts' of profit growth are rosy and, on top of that, price/earnings ratios in the stock market, even based on these rosy earnings forecasts, are very high. There are significant downside risks to the current level of stock prices, particularly through the first half of next year.
Stock prices have jumped up from their post-September 11 lows, and the risk premium on high yield debt has fallen back to its pre-September 11 level. Moreover, interest rates on high quality debt have risen sharply in recent weeks. The only way to interpret these developments is that investors are pricing in a fairly strong and certain economic recovery next year. Moreover, the forward term structure of interest rates through next year implies that investors are expecting the FOMC to raise the federal funds rate significantly after mid-year. Thus, investors currently seem to be betting that economic growth next year will come out on the HIGH SIDE of our forecast. In contrast, the FOMC in its latest statement maintained its concern regarding downside risks in the economy.
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FedViews is produced monthly, normally on the Friday or Monday following the second Thursday of each month. When these days immediately precede an FOMC meeting, distribution is delayed until the Friday morning following the meeting. The views expressed are those of the author, with input from the forecasting staff of the FRB San Francisco. They are not intended to represent the views of others within the Bank or Federal Reserve System. <<< |
