Economy heats up, looks to 2004
By Rex Nutting, CBS.MarketWatch.com
Last Update: 12:01 AM ET Dec. 15, 2003
WASHINGTON (CBS.MW) -- Like a couple of frustrated backyard chefs, Alan Greenspan and George W. Bush spent the past two years pouring more and more gasoline on the embers, trying to get the U.S. economy to ignite.
Finally, in the third quarter this year, FOOM!
The economy caught fire in the second half of 2003 and should burn brightly over the next year, fueled by tax cuts, federal spending and low interest rates, economists claim. Washington is doing its part, but so are Wall Street and Main Street.
"Everything is working in the same direction" for strong growth in 2004, said Joel Prakken, chairman of Macroeconomic Advisers, a top economic forecasting firm.
The outlook wasn't so rosy at the beginning of 2003. The year started with many question marks about the timing, and durability of the recovery. Deflation and stagnation were being seriously debated, as well as questions over the impending war in Iraq and whether terrorists might strike again. Would oil prices soar? Would corporate scandals and caution keep businesses from investing and consumers from spending?
The darkest days came in March, when both consumers and businesses retreated into their bunkers to wait it out. As it turned out, the worst did not happen.
"We won the war, even if we haven't yet won the peace," said Stuart Hoffman, chief economist for PNC Bank. The fall of Baghdad broke the spell that had been cast over the economy. "It changed the whole tone," Hoffman said.
It's unclear what impact Saddam Hussein's capture over the weekend will have on the economy or the financial markets, but geopolitical analysts indicate that they expect a mild uptick in the short term and, depending on the potential for further instability in the region, possibly strong benefits in the long run.
Changing tide
It took a third tax cut and a 13th interest rate cut to really get the economy moving in the second half of the year. From February through July, 510,000 jobs were lost, bringing the total during the recession and first year of recovery to more than 2.7 million.
But since then, 328,000 non-farm payroll positions have been added, the strongest job growth rate since the final months of 2,000. And in the third quarter, gross domestic product rose 8.2 percent in the third quarter, the best performance in 20 years.
"We are ending the year with a lot of momentum," Hoffman said. "It's a lot less iffy than a year ago."
Of course, the Fed and the Congress had been flooding the economy with money since early in 2001, putting a floor under the slowdown but not giving the economy much lift. What made 2003 different was the passage of time.
The tax cuts and interest rate cuts had boosted consumer spending and the housing market, but even a zero percent tax rate and a zero percent interest rate wouldn't make businesses invest when they couldn't see a profit.
The excesses of the late 1990s were still being unwound in early 2003. Businesses had invested too much and weren't inclined to build more with so much capacity lying idle and with investors and regulators demanding tighter controls on costs and balance sheets.
As profits recovered and demand improved through the year, businesses began to invest in equipment and software again.
"The excesses of business fixed capital have been entirely worked off," Prakken said. "In fact, there's now a slight shortfall. Businesses have allowed their fixed stock to run down."
At the same time, productivity gains were so strong that businesses could meet rising demand with fewer workers. Any need for extra help was filled by temporary workers and outside consultants, boosting the ranks of the self-employed.
By the end of summer and into the fall, however, businesses were beginning to hire more workers than they were letting go, although the pace of hiring remained weak.
Consensus forecast
The coming year could be one of the best growth years in decades. The Blue Chip consensus forecast for year-over-year growth is now 4.4 percent, nearly matching the 4.5 percent seen in 1997 and 1999, the best years of the 1990s.
"It's looking really strong," Prakken said. "Monetary conditions will remain quite stimulative." The Fed is unlikely to raise interest rates until 2005, he said. The rising stock market is lowering capital costs for businesses and giving upper-income consumers some extra wealth.
Consumers will get another windfall from the tax cuts when they file their 2003 tax returns. The tax cut was retroactive to Jan. 1, 2003, but employers didn't start withholding fewer taxes until July.
And the dollar will continue to fall, Prakken said. The global economy is "perking up," so exports should improve.
"And all of this is happening against an environment of very low and falling inventories," Prakken said. "Businesses will have to increase production."
"If the economy doesn't do better with all it has going for it, we'll have to rewrite all the textbooks," Hoffman said.
But despite the recovery, the U.S. economy remains far from perfect.
Plenty of economists lose sleep over the rising twin deficits. The federal deficit is expected to grow to about $475 billion for fiscal 2004, about 4.3 percent of GDP. The administration is promising to cut the deficit in half, but there are no plans to return to a surplus.
The balance of payments deficit will likely exceed $500 billion in 2003, with the prospect of some slight improvement in 2004 as the dollar weakens and U.S. exports rise.
The Fed and the Treasury have allowed and even encouraged the dollar to weaken. So far, the drop has been orderly, but no one can control or predict how global currency and capital markets will react under stress.
As long as the U.S. economy remains healthy, no one expects a dramatic decline in the dollar that could send money scurrying out of Wall Street and back to China, the Caribbean and Japan.
Inflation's new life
Inflation is another big question mark. The Fed and many economists expect inflation to remain very low as long as so much of the nation's labor and capital capacity are idle. But others warn that the Fed's low rates are giving inflation a new life.
The debate over inflation and the Fed's policy will intensify over the year, especially as the economy gathers strength. Markets are timing the first Fed rate hike for mid-year, but many economists don't see any move until late in the year or even into 2005.
Any rate cut in 2004 would likely be a modest beginning to bringing rates from 1 percent back to a more neutral level of around 4 percent. The Fed won't want to choke off the recovery.
There are other uncertainties as well, most centering around the consumer.
"Household spending is likely to slow significantly on a year-on-year basis," said Jan Hatzius, an economist for Goldman Sachs.
Although the labor market is improving, wage growth has slowed. Real weekly earnings are up less than 0.5 percent in the past year, one factor that drove consumer sentiment lower in early December.
Any extra compensation employees receive is going straight to their health insurance company.
Consumers took advantage of once-in-a-lifetime opportunity to fix their mortgage at a very low rate and to cash out their equity. That boosted spending in 2002 and 2003, but it won't in 2004.
Hatzius warns that fiscal policy will turn restrictive in the middle of the year and the household savings rate will rise, both serving to depress consumer spending. Goldman sees GDP slowing to a 3 percent pace by the end of the year, not fast enough to make much progress on bringing down the unemployment rate.
Job growth should keep consumer spending up, countered Prakken. He sees the jobless rate falling to around 5.5 percent by the end of the year from 5.9 percent this November.
Prakken estimated that payrolls would grow by about 2.7 million jobs in 2004, far ahead of more modest estimates offered by administration officials. Economists surveyed by the National Association for Business Economics forecast 2.3 million jobs would be created in 2004.
By the end of the year, both the Fed and the White House, fearing their eyebrows could be singed, may be ready to start cooling off a booming U.S. economy by raising interest rates and cutting back on federal spending.
Rex Nutting is Washington bureau chief of CBS.MarketWatch.com. |
