U.S.: After a Bruising, the Case for Optimism

Rate cuts, a liquidity boost, and breaks for business will speed up recovery

How bad will the economic damage be? While the outlook is still clouded by lingering uncertainty in the wake of the attacks of Sept. 11, two views are forming about the economy's future.

One is that a vicious cycle could cause real gross domestic product to shrink for perhaps as long as a year. Already, consumers stopped buying right after the attacks, and companies are warning about declines in business activity and profits. The sharp sell-off of the stock market from Sept. 17 to 19 suggests that many investors may be holding to this "worst-case" scenario.

Another view argues that any downturn will be brief, followed by a solid recovery. This seems the more likely forecast because monetary and fiscal policymakers around the world are using billions of dollars to stabilize the financial system and restore confidence. As a result, some economists expect U.S. real GDP to drop only in the third quarter.

Given the unprecedented tragedy and destruction of Sept. 11, the economy remains in uncharted waters. The best guides to the attacks' immediate effects will be the weekly indicators, along with some key monthly data tracking the mood of consumers (table).

CLEARLY, THE MOOD OF INVESTORS is pitch black. After being closed for four days, the stock markets opened to a fever of selling. The Dow Jones industrial average plunged 685 points on Sept. 17, the first day of resumed trading, another 17 points on Sept. 18, and then dropped 144 points on Sept. 19.

Undoubtedly, investors are nervous about war prospects or more terrorist attacks. But, most important, the drop indicates that investors see a weaker economy and heightened global uncertainty leading to bigger profit shortfalls than Wall Street had forecast prior to the attacks. Indeed, as the bad news continues to break over investors' heads, Wall Street is beginning to believe that the short-term costs to the economy might be higher than first thought.

This worst-case outlook holds that the economy was weakening before the attacks. Now, businesses are warning that the tragedy will cause profit targets to be missed by even larger amounts than anticipated. And many are announcing layoffs.

Under the pessimistic view, this bad news will trigger further drops in stock prices and impel nervous consumers to stop spending. Reduced demand will multiply Corporate America's woes, especially in the capacity-glutted tech sector. The upshot: even slower growth weakens profit expectations and stock prices further, which cycles back to less spending and growth.

A LARGE CONTINGENT of economists, however, have a more sanguine view of the future. They expect any drop in real GDP to last only a quarter or two. After that, the economy will rebound at a healthy clip. Moreover, any recession could be shallow by historical standards, since the economy had made some progress toward a pickup prior to Sept. 11. Excess inventories were shrinking, consumers were still spending, and policy was already accommodative.

The recent actions by policymakers both in the U.S. and around the world increase the likelihood of this so-called weaker-now, stronger-later scenario. These extraordinary times have brought out an extraordinary response. In particular, the Fed is working on two separate fronts: to assure adequate liquidity for the smooth functioning of the payments system and to boost confidence by cutting the interest-rate target (chart).

In the week ended Sept. 12, the Fed supplied an additional $11.7 billion in loans to banks, the largest weekly effort on record--dwarfing the activity following the 1984 Continental Bank failure. Weekly loans to banks typically average about $200 million. The figure will surely soar further.

On Sept. 14, the Fed bought some $80 billion in Treasury, U.S. agency, and mortgage-backed securities. Analysts at Credit Suisse First Boston estimate that the purchases were large enough to finance Wall Street's entire position in these assets. On Sept. 17, the Fed made $57 billion in additional purchases.

Internationally, the Fed pushed through several massive currency swap agreements with the world's other central banks, including a $50 billion arrangement with the European Central Bank. These efforts are geared to assuring the liquidity needs of foreign banks that are operating in the U.S. Moreover, the ECB, the Bank of England, the Bank of Japan, and others have all acted together to cut official interest rates.

THESE RATE CUTS, including the Fed's half-point cuts in its target for the overnight federal funds rate and the discount rate, to 3% and 2.5%, respectively, are aimed at instilling confidence in the future. But those cuts only partly validated the flood of new liquidity, since actual borrowing conditions are far more accommodative. The Fed's actions have, in essence, cut the cost of overnight loans to below 1%. On Sept. 19, the effective federal funds rate, determined by market forces, fell to 0.75%, more than two percentage points below the Fed's target.

Economists believe the Fed will take the funds-rate target as low as 2% in coming months. Since the Fed's preferred measure of inflation is also running about 2%, the move would push the real (inflation-adjusted) funds rate down to zero. That's about where it was when the Fed tried to restart the economy after the gulf conflict. And with inflation likely to go lower given shrinking global demand, the Fed has plenty of latitude to take the funds rate below 2% if necessary.

Working in tandem with easier monetary policy will be fiscal stimulus. Washington is already at work to provide industry subsidies and loan programs, additional tax cuts for both businesses and consumers, and new government spending.

In the next few weeks, some key reports will contain information on how Sept. 11 is affecting the economy right now. Already, the Instinet Research Redbook weekly survey of retail activity showed ominous results. Sales in the first week of September were weak, down a seasonally adjusted 0.7% from all of August. In the week ended Sept. 14, store purchases plummeted 3.2% (chart).

An intra-month shift of that magnitude is enormous for this report, suggesting that the government's measure of sales for the month will be down sharply. However, if the falloff merely reflects people staying home to watch TV, then the reading probably overstates the likely degree of retrenchment in the following weeks.

The coming data will lay out the economic risks that investors, businesses, and consumers will have to live with over the next few quarters. But keep in mind that resiliency and adaptability have been the hallmarks of the U.S. economy. Those traits will be needed more than ever in the year ahead.

By James C. Cooper & Kathleen Madigan

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