U.S.: The Recovery Gains Traction after a Muddy Autumn
As economic seers turn their attention to 2003, keep in mind an old saying among forecasters: The consensus is always wrong. That's especially true around turning points in the business cycle. The real trick is to decide which way the muddle in the middle will err: Will the consensus be too optimistic or too pessimistic?
In the coming year, the economy will most likely overshoot the consensus forecast of 3.2% growth (page 70). The Iraq factor will be an early hurdle, but the economy heads into the new year with a solid base supplied by the three P's: policy, prices, and productivity.
First, the combination of monetary and fiscal policy is already as stimulative as it has been at any time since World War II (charts). On the fiscal side, the policy boost can be seen in the swing in the federal budget, which captures how changes in taxes and spending affects the economy. In fiscal 2002, which ended Sept. 30, the budget took a record swing, from a surplus of $127.3 billion in 2001 to a deficit of $159 billion, an economic thrust of some $286 billion, or 2.8% of gross domestic product.
The deficit is expected to widen further in 2003, to perhaps $225 billion. But the fiscal boost could be even greater than that, since the Bush Administration and the new Republican Congress are sure to push through another sizable stimulus package (page 40). Some, but not all, of the federal lift will be offset by higher taxes and less spending on the state level. State budgets are expected to be in the red by some $60 billion for the coming fiscal year, and unlike Washington, most states must balance their budgets by law.
BUT MONETARY POLICY has not been stingy, either. In fact, you have to go back more than two decades to find a period when the Federal Reserve was as stimulative as it is now. That's clear from the current level of the Fed's policy target, the overnight federal funds rate, adjusted for inflation. Based on the latest consumer price index--which showed yearly inflation at just 2.2% in November--and a fed funds rate of 1.25%, the real policy rate is -0.9%, compared with a long-run average of about 2%. That's the widest gap and the most negative real rate since the 1980 recession.
Equally important to the outlook is the fact that the Fed will be willing--and able--to keep policy exceptionally accommodative toward economic growth. For the first time since the early 1960s, the Fed has achieved its long-run goal of price stability. Practically defined, that means inflation is so low that it is not a factor in business decisions or buying behavior.
At price stability, the Fed must treat both inflation and deflation with equal respect, so monetary policy in 2003 will not be a one-sided effort geared toward cutting inflation, as has been the case for most of the past 40 years. The beneficiary of this new policy imperative will be the recovery, because the Fed has unprecedented leeway to err on the side of stimulus.
THAT DOESN'T MEAN deflation will be a worry in 2003. On the contrary, with stimulative policy helping to boost demand, the economy's second P, prices, are showing signs of firming up. In particular, commodity prices are rising. The Commodity Research Bureau's spot price index of industrial commodities, which does not include energy items, is 10.8% higher than it was a year ago and at its highest level in almost two years. Rising commodity prices are not an inflation indicator but a sign of healthier demand.
Stronger prices are showing up in the early stages of the production process. In the year ended November, 2001, core prices for crude goods fell 9.6%, but now they are up 11.6% from a year ago, reflecting the gain in commodity prices. For intermediate supplies that go into finished goods, such as fabrics and electronic components, trends have also shifted. A year ago, these prices fell 1.4%; now they are up 1.4%.
Domestic-goods prices are also starting to get a lift from the declining dollar, which makes imported goods more expensive and provides some cover for U.S. producers to charge more. Since February, the trade-weighted dollar has declined about 10%. The drop has accelerated in recent days, as investors and traders began to question Treasury Secretary nominee John W. Snow's commitment to a strong dollar. Thanks in part to the dollar's slip since February, prices of nonoil imported goods have risen 0.8%, after declining sharply during the previous year.
Another key reason for optimism is the third and perhaps most important P: productivity. The best yearly productivity performance in two decades is supplying its own boost to demand by lifting the profitability of businesses and the real wages of workers.
In fact, the recovery is looking more and more like the expansion of the early 1960s--a period of high productivity, characterized by low inflation and interest rates, and rising profitability and real wages. The most important point to take from the '60s is that companies made money even when pricing power was hard to come by. Using that precedent as a guide, Corporate America could post some positive profits surprises in 2003. That's especially likely if demand proves to be stronger than now expected.
IN FACT, THE LATEST DATA strongly support the notion that the economy is emerging from its autumn soft spot. In particular, both retail sales and industrial production in November bested expectations, indicating that consumers are brightening the holidays for retailers and that manufacturers are stirring back to life.
Everyone expected the end of zero-rate car financing to crimp the overall data for retail sales in October and November, and it did. But the real story is that, excluding autos, retail sales jumped 0.8% in October and 0.5% in November (chart). The combination of strong demand and cautious ordering has left some retailers short of inventories. So far this year, sales at manufacturers, wholesalers, and retailers have risen more than three times faster than their stockpiles.
Lean business inventories suggest some improvement is on the way for manufacturers. In November, industrial output rose a slim 0.1%, but it was the first increase since July, led by a rebound in auto output. Production of business equipment continued to decline in November, but the losses are narrowing, and output at high-tech industries posted a 0.6% advance for the second month in a row.
While manufacturing has a long way to go before it recovers completely, the economy's quick skip over its soft patch indicates how prices, policy, and productivity have kept demand healthy despite the summer's stock market decline, geopolitical risks, and the overall paralysis of the business sector. In 2003, look for the economy to continue benefiting from this trio of P's. And don't be surprised if many forecasters become a little more optimistic as the year progresses.
By James C. Cooper & Kathleen Madigan