Federal Reserve Chairman Alan Greenspan sounded optimistic during his Feb. 13 Congressional testimony on the economy. But he might have had his fingers crossed under the table. As he knows full well, the economy's shift from a high-flyer to a lower altitude is changing the way investors, consumers, and businesses conduct their daily lives. And that transition is creating risks for all.
For investors, slower economic growth means reduced expectations and increased uncertainty, quite a different climate from what they had become used to. Households are learning that job prospects and stock market gains are not without limits, so their faith in the future has been shaken. And businesses are learning that plans for capital investment and inventories that were based on 5% economic growth don't make sense in an economy growing at half that pace--or less. All this raises the question: Will the transition be smooth, bumpy, or a train wreck?
So far, the latest readings are encouraging, especially those from the household sector. In January, retail sales bounced back from their poor December showing (chart), as car sales rebounded strongly. Falling mortgage rates have unleashed a barrage of refinancings that will put extra cash in people's pockets. And January job growth looked better. The ability and willingness of consumers to keep spending, even if at a slower rate, is the key to avoiding the train-wreck scenario.
THE FED CHIEF suggested that the adjustment will be quick and not too painful, especially in light of the Fed's rapid reaction. Asked point-blank if the economy was in a recession, he replied: "At the moment, we are not." The Fed is forecasting economic growth of 2% to 2.5% for 2001, with joblessness rising to 4.5% and inflation edging down. If the first half is as sluggish as most observers expect, then the Fed's growth projection implies a significant pickup in the second half.
At the same time, though, Greenspan suggested that further aggressive rate cuts may be required to assure continued growth. He said that for the period ahead, "downside risks still predominate." Topping his worry list is a possible break in consumer confidence, along with the unknown extent of the inventory adjustment, a slowdown in foreign economies that could hurt exports, and lender nervousness in the financial markets.
But so far, those are just worries, and they are mitigated by the consumer turnaround in January. Retail sales rose a strong 0.7% from December. Excluding the rebound in car buying, sales posted a broad 0.8% gain. The numbers suggest that any inventory problem that retailers faced at the beginning of the year has been quickly pared to a much smaller problem in only one month.
More important, they imply that consumers are not retrenching in a way that could push the economy into a recession. If consumers stop spending, the already tough transition to slower economic growth facing the corporate sector would become extremely difficult for businesses to make without the consequences falling back on both households and the stock market.
THE FIRST HURDLE for businesses is to cut inventory levels that seemed appropriate when demand was booming, but that now look excessive. That process was already under way at yearend (chart). Business inventories rose only 0.1% in December, sharply slower than the average 0.6% monthly pace of the previous six months, and well below the pace that the Commerce Dept. had assumed in its report on fourth-quarter gross domestic product. That means the inventory drag on real GDP growth last quarter was much greater than first reported, and that the drag in coming quarters may well be less than initially feared.
To be sure, further stock-level adjustment will be needed. Although the ratio of inventories to sales held steady in December, the desired inventory level of businesses has been trending downward during the past decade. As Greenspan pointed out, after adjusting for that downtrend, the inventory imbalance looks "considerably larger." Indeed, the trend-adjusted data show that the December ratio of inventories to sales is at a level not seen since the 1990-91 recession.
Another problem facing businesses is that productivity growth is shifting down with the economy. Even though productivity's long-term trend remains favorable, a short-term cyclical problem is cropping up. The Labor Dept. reported that productivity in the fourth quarter grew at a strong 2.4% annual rate from the third quarter. However, the four-quarter pace of productivity has fallen from a peak rate of 5.4% to 3.4%, at a time when labor compensation was speeding up from 4.9% per year to 5.7%.
As a result, the second half of 2000 saw the fastest two-quarter growth in unit labor costs since 1993, severely crimping profit margins. Second-half unit labor costs rose at a 3.7% annual rate, while prices increased only 1.6%. That's why BusinessWeek's measure of fourth-quarter profits fell 11% from a year ago, while revenues were up 17% (page 52). The squeeze puts profit expectations of investors at risk, and it heightens the pressure on companies to cut payrolls.
GREENSPAN NOTED that higher energy costs were also applying pressure to profits. He said that more than one-fourth of the rise in total unit costs among nonenergy, nonfinancial corporations reflected costlier energy, both directly and via reduced overall demand. But the general lack of pricing power prevented any broad inflationary impact.
However, as Greenspan emphasized, these are temporary cyclical developments that will run their course. In the coming year, looser labor markets and lower energy prices are likely to relieve some of the cost pressures, and the Fed chief reiterated his belief that "the prospects for sustaining strong advances in productivity in the years ahead remain favorable." Indeed, the five-year growth rate of productivity is 2.8%, up from 1.5% in the previous five years (chart).
Perhaps the biggest risk in the outlook is capital spending. The gap between corporations' capital outlays and their cash flow has never been so wide. That means internally generated funds are increasingly insufficient to maintain current spending levels, just at a time when credit from external sources, such as banks and the credit markets, is scarcer. However, as long as demand by consumers and foreigners holds up reasonably well, the slowdown in capital spending will not turn into a crash.
The key feature of this transition to slower growth is that technology and the speedier flow of information appear to have quickened the adjustment. The big plus is that the Fed has reacted with increased haste. As Greenspan put it on Feb. 13, "economic policymaking could not, and should not, remain unaltered in the face of major changes in the speed of economic processes." That resolve gives this expansion a fighting chance.
By James C. Cooper & Kathleen Madigan
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Copyright 2001, Bloomberg L.P.
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