Investors are clearly disturbed that the Federal Reserve's six interest-rate cuts have not yet had a big impact on the economy. And the leaders of G-8 industrial nations negotiated ineffectively July 20-22 on how to resuscitate a weakening global economy even as bands of anarchists laid siege to the streets of Genoa.
ON THE MEND. The market may be fragile, but it does appear that the economy is healing. For instance, America's trade imbalance with the rest of the world unexpectedly narrowed as exports expanded and imports slowed. The fact that the trade deficit shrank despite the dollar's overvaluation has convinced many economists, including Maury Harris, chief economist at UBS Warburg, to revise forecasts for gross domestic product (GDP) growth in the second quarter from a negative to a positive figure.
Indeed, any bet that the economy is turning around rests on a belief that consumers will remain upbeat. After all, it's thanks to consumer spending that the economy has skirted recession so far in 2001. Lower energy prices are buying both consumers and business some financial relief. The closely watched measures of consumer confidence have stabilized. "The fabric of consumer confidence hasn't been breached," Federal Reserve Board Chairman Alan Greenspan told the Senate Banking Committee on July 24.
Why has consumer spending stayed so robust? One factor is that consumer wealth remains high despite the dismaying news that the value of retirement savings plans is down. American households had a total net worth of $39.6 trillion at the end of the first quarter. That staggering sum is down 8.5% from a record level a year ago, but up $21 trillion -- or 112% -- since the third quarter of 1991, according to Ed Yardeni, chief investment strategist at Deutsche Banc Alex. Brown. And the stunning rise in real estate values has shored up the consumer balance sheets. For instance, real estate assets are up 11% to $11.3 trillion year-over-year.
GOOD NEWS. There may be another reason why consumer spending has stayed strong despite the downturn in the stock market. Investors were never as irrationally exuberant as Wall Street lore suggested during the height of the stock market bubble in the late 1990s. If so, the bursting of the dot-com bubble and the collapse of the Nasdaq index may have inflicted far less trauma on the consumer psyche than many Wall Street analysts anticipated.
This insight comes from mulling over some investor survey data collected in a recent paper, Blowing Bubbles, by Kenneth L. Fisher, chairman of Fisher Investments, and Meir Statman, finance professor at Santa Clara University. For instance, the Paine Webber Index of Investor Optimism asks what rates of return individual investors expect during the next 12 months. The mean stock market return predicted in December 1998 for the following year was 12.10%, 15.3% in December 1999, and 10.5% in December 2000.
At the same time, the BusinessWeek Survey of Institutional Investors had a mean return expectation for the same time periods of 1.56%, 7.22%, and 19.20%. And an academic-directed survey of finance economists came up with these numbers: 10.28%, 11.28%, and 11.69%. These figures are far from absurd stock-market expectations or evidence of irrational exuberance considering that the mean annual return of the Standard & Poor's 500 index from 1926 to 2000 was 12.98%.
FEDERAL RESERVE'S INFLUENCE. To be sure, some Fed-watchers wonder if the central bank has lost its ability to influence the economy through changes in the federal funds rate (what banks charge each other for overnight loans). But monetary policy has clearly worked to keep up consumer spirits. The Fed's rate cuts have helped keep long-term mortgage rates down, spurring a wave of new home buying and mortgage refinancings. Adjustable-rate mortgage applications have jumped from 7.4% of the total in April to 11.3% in July, according to the Mortgage Bankers Assn.
Washington also has started mailing out federal income tax rebate checks. To be sure, some rebate money will pay down credit card debts or into savings accounts. But a fair amount of the $40 billion sum will likely be spent on vacation or at the mall, especially with the back-to-school season almost upon us.
Of course, everyone wonders whether consumers will keep on spending with the job outlook so worrisome. Lucent Technologies plans on laying off another 20,000 workers, and jobless claims are at a nine-year high. But my guess is that those consumers still employed will keep on shopping. Plus, the Fed could always cut rates again. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BW Online