Will The Slowdown Become A Slump?

A "growth recession" might feel like one

Temperance is a painful adjustment after a two-year binge. For the investors, businesses, and households that thought 5% economic growth was just part of the joy of the New Economy, 2001 will usher in a sobering reality.

It's a classic case of the Federal Reserve taking away the punch bowl. The Fed's six hikes in interest rates, totaling 1 3/4 points, have resulted in tighter credit markets, slumping stock prices, and pickier banks, so much so that on Dec. 5, Fed Chairman Alan Greenspan suggested that some easing might be needed. Even so, the more restrictive financial conditions already in place will curb spending by both consumers and businesses, slowing 2001 economic growth to 3.1%, measured by real gross domestic product.

That's the average projection of 54 of the nation's business economists, as surveyed by BUSINESS WEEK, and it's only a shade above the expectation of the fearless forecasters here at the magazine (table). No one is forecasting an outright recession, although most admit that the risks to growth are rising. The chief concerns: A broad plunge in stock prices, another jump in oil prices, a credit crunch, or a swooning dollar.

"We may be at the onset of the first `growth recession' of the New Economy era," says Joseph Liro of Stone & McCarthy Research Associates. That means a period of slower growth at a rate below the economy's long-term trend, causing the unemployment rate to rise. A slowdown is not a slump, but most forecasters agree that people face a tough slog adapting to a period of diminished expectations and increased risk--a very different climate compared with the past few years. However, as Liro adds, "coming off several years of robust growth, the perception of the slowdown will be worse than the reality."

The adjustment by consumers will have a big impact. Pumped up by unprecedented wealth gains, consumer spending has grown at a 5.3% annual rate for the past two years, more than two percentage points faster than aftertax income, and contributed 84% of real GDP growth in 1999 and nearly 90% through three quarters of 2000. "With the wealth effect now neutralized, consumer spending is likely to grow more closely in line with income, which I think will be about 3%," says Richard D. Rippe at Prudential Securities Inc. Although the labor markets will loosen up a bit, the jobless rate is generally expected to rise to only 4.3%, hardly enough to dent income growth by very much.

Capital spending by businesses, especially for high tech, also will play a crucial role in the slowdown. But despite the outlook for slower demand, tighter financial conditions, and softer profit growth, no one expects business investment to collapse. The folding of many dot-coms and other tech companies, plus a tapering off of the breakneck pace of tech growth, will be felt. But as Greenspan said on Dec. 5: "The orders and output surge this past year in a number of high-technology industries, amounting in some cases to 50% and more, was not sustainable even in the more optimistic New Economy scenarios."

Long-term structural forces still support tech spending. "Competitive pressures and ever-shortening product cycles will continue to demand healthy rates of investment spending over the next few years," says Michael P. Carey at Credit Lyonnais. Stephen Slifer at Lehman Brothers Inc. is more blunt, saying: "The firm that does not spend money on technology will, before long, be out of business." All this means that the upshift in the long-term growth rate of productivity will remain in place.

The short run, however, is where the outlook gets tricky. As the economy slows, productivity will slow as well, even as labor compensation continues to grow rapidly. "If compensation doesn't slow commensurately, then businesses will either raise prices more aggressively or their profit margins and stock prices will erode," says Mark M. Zandi of Economy.com Inc. Either way, the economy's performance will suffer.

Most forecasters believe that slower growth and stiff competition will restrain prices at the expense of profits. "Leading indicators of inflation, including the prices of gold and nonoil commodities, bond yields, inflation expectations, the yield curve, and money growth, all suggest that inflation remains in check," says Jim Coons of Huntington National Bank in Columbus, Ohio. In particular, the forecasters are betting that oil prices have peaked, and that overall inflation, measured by the consumer price index, will fall by a percentage point by the end of 2001, to 2.5%.

However, core inflation, which excludes energy and food, may well creep higher, as it did throughout 2000, reflecting faster-rising service prices, especially for housing and medical care. Christopher Low of First Tennessee Capital Markets isn't worried. "We saw the same kind of uptick in core inflation in 1995, after the economy overheated in 1994," he says. "But once the Fed reined in growth, inflation came back under control."

The problem for the Fed is that labor markets are far tighter now than they were then, when the unemployment rate was 5.5%. Although the risk of overly weak growth in coming quarters has risen, the risk of rising inflation still has not come down. While most forecasters expect one or two quarter-point cuts in the federal-funds rate in 2001, 28% expect no cut or further hikes.

For 2001, at least, the Fed will retain the policy freedom it has enjoyed in recent years, without the complication of big tax and spending initiatives from the new White House and Congress. "No passage of tax legislation would be possible before the summer recess in August, and very likely not until late 2001 or early 2002," says Allen Sinai of Decision Economics Inc. Moreover, economists agree that the Fed will not alter policy based on uncertain legislative prospects. If the Administration does carry through with a new tax-cutting and spending agenda, Sinai believes the financial market reactions will be "negative in fixed income, positive for stocks, and positive for the dollar."

Of course, increased globalization will also play a key role in the outlook. Slower growth in Europe and Asia will limit U.S. export growth (table), but foreign shipments should not grow by much less than the expected 9% pace in 2000, buoyed especially by exports of capital equipment. "The U.S. will retain a large comparative advantage in the high-tech sector, even if domestic demand slows," says Michael R. Englund of Standard & Poor's MMS. But while U.S. import growth will cool from about 12% in 2000, that will not be sufficient to prevent a further widening in the trade deficit.

Therein lies one of several risks for 2001: The trade deficit--and the ever-growing external financial obligations that come with it--could unwind faster than the markets can smoothly accommodate, especially if the U.S. economy weakens more than expected. "This could lead to capital flight from the U.S., a sharp depreciation in the dollar, and more complications for Fed policy," says Diane Swonk of Bank One Corp.

Another risk: A spike in oil prices, to $45 or $50 per barrel, could hit hard in a more vulnerable economy. However, OPEC would find that level tougher to hold amid slower world growth. A credit crunch is also a threat, although, as Bill Cheney at John Hancock Financial Services says: "That's something that the Fed can react to on a dime as soon as it's really visible."

But perhaps the biggest danger in the outlook is the stock market--and not just the tech-laden Nasdaq. Stock prices have never in the postwar period played such a large role in determining demand by consumers and businesses, especially through the wealth effect on consumer spending. The threat is a potentially vicious cycle in which slower growth cuts into earnings expectations, which hit stock prices, further eroding growth and earnings expectations, and so on. That's a recipe for a serious recession.

Still, the forecasters are optimistic that Greenspan & Co. will keep things moving along. So don't worry--2001 won't be a funeral, but you can put away those party hats for a while.

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