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A Tricky Transition By Mark Zandi 12/28/00 8:30 AM ET
The U.S. economic expansion currently faces its most serious threat since the mid-1990s. As in that period, the economy is currently struggling as its adjusts to a significant tightening in monetary policy motivated by concerns over developing inflationary pressures. Policymakers succeeded in their efforts during the mid-1990s and the economy subsequently went on to arguably experience its best five-year performance in history. It is unlikely that policymakers will be nearly as successful in coming years.
Complicating matters today are high energy prices. The price of West Texas Intermediate has more than tripled over the past two years to its current close to $30 per barrel. Natural gas prices have also tripled to a record close to $6 per million BTUs, and even electricity prices are rising despite the industry's deregulation. Oil prices in the mid-1990's, in contrast, were closer to $20 per barrel.
Of the nine recessions since World War II, all but the 1960 recession were preceded by a significant increase in oil prices. The higher prices have the economic impact of a tax increase, but are even more pernicious since they hamstring monetary policymakers who are fearful of easing policy and thus fanning inflationary expectations. While the recent hike in energy prices seems somewhat less onerous, as they are relatively small on a real basis and the economy has become less energy dependent, policymakers have stated that the higher energy prices are a factor in their decision to maintain their currently tight policy stance.
The taught labor market also makes the current period more difficult for policymakers to navigate through. In the mid-1990's unemployment was hovering near 5.5%, compared to closer to 4% currently. With no apparent remaining slack in the economy (even Federal Reserve Board Chairman Greenspan has recently expressed his view that a 4% unemployment rate is consistent with full employment) policymakers must remain particularly cautious. Any re-acceleration in economic activity would quickly ignite wage and price pressures.
Policymakers must also grapple with the increasingly strong links between the economy and stock market. Especially difficult for policymakers to gauge is the contribution of the equity market in providing the ample and cheap credit necessary to finance the investment boom that has fueled the unprecedented acceleration in productivity growth in recent years. If policy is too tight so that it cripples the equity market, then the investment and productivity gains that are at the heart of the new economy will be undermined. If policy is not tight enough and the equity market quickly rebounds, then growth would reaccelerate, resulting in lower unemployment and an overheating economy.
Just as the performance of financial markets to the health of the economy has gained in importance, policymaker's influence over that performance has waned. This is in large part due to the ongoing globalization of U.S. financial markets driven by the nation's burgeoning current account deficit. Since the mid-1990's, the deficit has ballooned by more than four-fold, with foreigners using those dollars earned in trade to purchase U.S. stocks and bonds. Foreigners now own 8% of U.S. corporate equities and 35% of Treasury bonds, up from 6% and less than 20%, respectively, in the mid-1990's.
Foreign investors make decisions to invest in U.S. securities based on their expected returns relative to returns on other global assets. To date, foreign investors have been very willing to snap up U.S. assets that had until recently been appreciating strongly in value. This could of course change quickly, particularly given the recently soft equity market. Adding to this risk is the extraordinary strength of the dollar, which continues to soar versus virtually every other currency from the euro, to the Canadian dollar to the Japanese yen. Any sense that the dollar is peaking could quickly induce foreign investors to unload their U.S. assets.
The economy also appears more vulnerable to an unforeseen shock today than in the mid-1990s, due to high and rising leverage among lower income households. Aggregate household debt burdens are approaching the record highs set in the mid-1980s, and the rising indebtedness is surely not among higher-income households. Most of these households own homes and stock portfolios that have appreciated strongly in value, and who have been able to lock in low interest rates in the mortgage refinancing waves of the 1990s.
Even with the currently low unemployment and strong income growth across all parts of the income distribution, financial stress among lower income households is already evident. Personal bankruptcy filings are rising again for the first time in more than two years. According to Visa, close to 80% of filers last year had incomes of less than the nation's median annual family income of $50,000. With these households accounting for as much as one-third of total consumer spending, their mounting financial problems could be a serious problem for the entire economy.
While the expansion is at increasing risk, in some respects policymakers have more latitude today than in the mid-1990's to quickly address any erosion in the economy's performance. Most importantly, underlying productivity growth is currently as strong as it has been since the 1960's. Strong gains in productivity reduce the possibility that policymakers will err by over-stimulating the economy and igniting accelerating inflation.
Also widening policymakers' margin of error are currently low and tame inflation expectations. According to surveys of economists and households conducted by the Philadelphia Fed and University of Michigan, respectively, and implied inflation expectations embedded in Treasury inflation protected securities, households, businesses and investors believe today's currently low inflation is here to stay. These sanguine inflation expectations will help forestall any significant actual acceleration in inflation.
The most likely outlook (60% probability) thus remains that policymakers will be able to guide the economy through what will be its most difficult period since the mid-1990's. The economy's performance will erode, but only modestly. Real GDP growth will slow from over 5% this year to closer to 3% next year, core CPI inflation will accelerate modestly from 2.5% to 3%, and the jobless rate will rise from near 4% currently to 4.5% at year-end 2001.
There is not an inconsequential probability, however, that the economy will experience a more difficult time next year. A growth recession, characterized by growth that is insufficient to forestall significantly rising unemployment (20% probability), or a full-blow downturn, characterized by falling output and rapidly rising unemployment (10% probability), are not inconceivable.
The economy's performance could turn out to be even better than anticipated, if say productivity growth continued to accelerate. Indeed, economists and policymakers have consistently underestimated the economy's potential in recent years. While possible, however, this optimistic outlook is unlikely (10% probability).
-- Ken Decker (firstname.lastname@example.org), December 28, 2000
Sounds like a 20% chance of cooler weather, with a 10% chance of snow but also a 10% chance of warmer weather, but we're not very sure how much warmer or how much snow. Do meteorologists and economists use similar models?
I notice that the weatherman never does a backcast, but focuses strictly on guessing tomorrow's weather. Conversely, economists often seem to use their prediction of nearly everything to justify their efforts. So whatever happens, it's "as predicted (10% probability)". Nice work if you can get it.
-- Flint (email@example.com), December 28, 2000.
Actually, yes. Economic models have much in common with weather models. Both try to predict the behavior of complex systems. Unfortunately, Newtonian calculus is not up to the task. Chaos theory offers interesting insights into complex systems... but we cannot translate theory into models without mathematical tools. Perhaps some 21st century Newton will give us these tools.
-- Ken Decker (firstname.lastname@example.org), December 29, 2000.