Slowdown: Not If, But How Long

Why sluggishness may linger

In early December, most economists still saw a soft landing ahead for the economy. Now, following a spate of downbeat economic news, expert opinion has swung toward the view that either an outright recession or something approaching it is unfolding, and the critical question has become whether the slowdown will be V-shaped or U-shaped--that is, relatively short- or long-lived.

One seasoned observer anticipating a U-shaped slowdown is James Paulsen, chief investment officer of Wells Capital Management, whose growth forecast of just 1.7% for 2001 was the most bearish among the 53 private-sector economists cited in BUSINESS WEEK's yearend survey (Dec. 25). Paulsen believes the next year or two will resemble the prolonged sluggishness that characterized the economy in the early 1990s.

The Minneapolis-based economist ticks off several reasons for his dour outlook. With consumer spending in recent years tied to a stock-market-driven "wealth effect," he worries that the impact of the Federal Reserve's easing on the market may be diminished--that it may be seen by investors as proof that the economy is in trouble. Until stock prices fully recover, households will be prone to save more and spend less.

Even if the market recovers, Paulsen thinks consumption may stay restrained. The reason: The economy in the '90s experienced its longest big-ticket spending spree ever, bringing outlays on durable goods and structures to a postwar high (chart). "Households are flush with new homes, furniture, cars, and computers," he says, "and many businesses are overinvested. Demand is saturated for a while, no matter what the Fed does."

The Fed is also hamstrung, Paulsen believes, because monetary policy won't get much help from the refinancing of debt at lower interest rates. In the 1970s and much of the '80s, he notes, it didn't pay for most consumers and businesses to refinance their long-term debt because interest rates stayed relatively high. In the 1990s, by contrast, rates hit new lows several times, allowing households and businesses to reap huge cash-flow injections via refinancing. "Much of the economy is now refi'ed out," says Paulsen, "and it would take a massive further drop in rates to start the refi ball rolling again."

He also is concerned about the uncertain shape of the technology cycle. While the high-tech boom seems to be fading, many economists believe the sector marches to its own tune and is less sensitive to monetary policy and the general state of the economy than other sectors. Although this implies that tech spending won't tank in a slowdown, it also suggests that it may not respond very much to lower yields.

Finally, Paulsen worries that the Fed cannot count on a weaker dollar to help revive the economy by spurring exports and restoring domestic pricing power. With growing fears of a global slowdown, he says, foreign investors may still prefer the dollar as a safe haven even as U.S. interest rates are cut.

In sum, Paulsen thinks the chances of a bounceback in growth are small. "The Fed," he says, "is likely to find that the economy is far less responsive to monetary ease than earlier in the cycle."

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