U.S.: Are We Talking Ourselves Into A Recession?
Can gloomy talk doom the expansion? In the past, economists dismissed the notion that psychology can dominate real economic forces. No matter how many downbeat headlines people read, the theory went, the outlook always comes down to basics such as jobs, incomes, and profits.
But in today's economy, the past may no longer be prologue. That's because psychology does indeed have a huge impact on the stock market, and never before has the market played such a big role in real economic activity. It was market psychology more than fundamentals that drove technology share prices up so rapidly in 1998 and 1999. The resulting surge in wealth was the jet fuel that powered the growth rate of consumer spending and the economy into the 5% to 6% range, causing the Federal Reserve to put on the brakes.
Now, psychology has turned sharply. In addition to market worries and a negative spin by the press on almost every new piece of data, the Bush Administration has warned that the economy may be headed for a recession. Such talk is meant to promote the new Administration's tax-cut program, but downbeat sound bites can hit home. No wonder households were more pessimistic in December.
Sentiment, especially on Wall Street, is so negative right now that the surprisingly big shift in the Federal Reserve's thinking about the possible need for lower interest rates failed to lift spirits. In fact, the stock market went south in a hurry after the Fed's decision on Dec. 19 to keep rates on hold, even though the central bank shifted its major concern for the future away from inflation and toward economic weakness. Wall Street was disappointed that the Fed didn't cut rates, even though almost every economist polled before the meeting had expected no change.
THE QUESTION GOING FORWARD is whether economic fears can become self-fulfilling prophesies. If recession talk continues to throttle stock prices, the decline in wealth may well kill spending plans by both consumers and businesses. Demand could easily fall off more sharply than is now expected, resulting in an increase in profit warnings. Equity prices would drop even more, causing steeper declines in wealth and demand. The soft landing would become a crash.
Why, then, didn't the Fed simply cut rates in December? Unfortunately, policy decisions are no longer simple in a world where the stock market greatly affects economic activity. Keep in mind that the Fed doesn't want to reignite the very same stock-market forces that created the excessive demand growth that the central bank wants to eliminate. But if rate cuts end up boosting the market, the economy would get two injections of stimulus from Fed easing: lower rates and the wealth generated from higher stock prices.
Policymakers also know that the market's sway over demand adds greatly to the uncertainty in the economic outlook for 2001. Slower growth makes the economy more vulnerable to outside shocks, such as higher oil prices. But now, jolts will hit the economy from two angles: the direct effect on real business activity, and the indirect impact from the stock market, as negative psychology hammers stock prices and wealth and thus spending. Add it all up, and the stock market's increased influence means that the Fed has to walk an unusually fine line in 2001.
AT LEAST FOR NOW, the Fed seems more confident about the economy than the markets are. No question, the data look soft, especially from manufacturing. But nothing in the latest readings on everything from durable goods orders to consumer spending to industrial production argues that the economy is so weak that it urgently needs lower interest rates (charts).
Consider consumers. Households were clearly less optimistic in December, reflecting worries over the stock market, election uncertainty, and downbeat headlines. But while consumer spending is slowing, fourth-quarter outlays appear to have held up well. Even if December purchases of goods and services post no gain from November, spending will show a 3.2% annual rate of growth from the third quarter. That would be slower than the third quarter's 4.5% pace, but it's not too shabby--and nowhere near a recession reading.
Moreover, much has been made of weak holiday spending, but 2000's retail performance is being judged against the extraordinarily strong sales of yearend 1999. Back then, overall consumer spending was growing at a clip of close to 6%, and yearend retail buying was boosted sharply by millennium spending and by outlays made in advance of possible computer-related outages resulting from the century date change. Retail performance in 2000 will surely pale in comparison to the 1999 binge, but it will still be consistent with a healthy, if slower, pace of consumer spending.
THE MANUFACTURING SECTOR is the area of the economy that is truly struggling right now, as it typically does in response to a round of Fed tightening. Industrial production has slowed substantially in recent months, with factory output falling 0.5% in November. But while the slowdown is broad, keep in mind that declining auto production has accounted for a disproportionately large share of the weakness. Vehicle output dropped 2.8% in November after a 3.6% plunge in October, as car makers struggled to cut overly heavy inventories.
Autos account for much of the inventory overhang in the economy right now. In fact, they are responsible for all of the recent rise in the ratio of inventories to sales in the retail sector. Excluding motor vehicles, the ratio of retail stockpiles to sales has not risen at all (chart).
Another key factor in manufacturing's softness is the slowdown in output of high-tech goods. But even here, circumstances appear to be extraordinary. In the first and second quarters of 2000, production of computers, peripherals, electronic components, and communications equipment grew at annual rates greater than 70%, far above the steady 35%-to-40% pace that had characterized output growth from 1997 to 1999.
However, the first half's 70% growth rate was just as anomalous as the fourth quarter's slowdown to about 20%. The production surge followed a yearend 1999 slowdown, as companies froze their tech budgets in advance of the Y2K change on the world's computers. Now, tech output is slowing, but to a more sustainable pace. It is not collapsing. In fact, the ratio of inventories to sales for tech goods continues to fall, suggesting that demand and output remain in balance.
The point is that despite all the negative talk and worry, economic activity, while slower, is holding up. But the longer that downbeat sentiment continues, the more likely it becomes that a hit to the stock market could do in the long-running expansion--despite the Fed's best efforts to keep that from happening.