What Postwar Pickup?

There's growth -- but not enough to rev up the job engine

As the U.S. economy limps through its third post-boom year of sluggish growth, policymakers from Federal Reserve Chairman Alan Greenspan on down have been counseling patience: Let the healing process run its course. Yes, the profits, investment, and jobs picture looked bleak during the dark years. But the underlying economy is basically strong, and a second-half pickup is just around the corner. It's a familiar refrain, and this year, the catalyst for robust growth was supposed to be the speedy end to the Iraq war. Many, including Greenspan, counted on a decisive rout to lower energy prices and sweep away economic uncertainty.

But after three years of "wait for the second half" blandishments, reality hit home with a thud on May 6, when Greenspan and his central bank colleagues warned of the danger of deflation -- a broad decline in prices that's often a harbinger of malaise. While the Fed doesn't think that's likely, the acknowledgement that such a risk has increased shows how high the stakes are for the struggling economy.

The bottom line: With the postwar bounce so far AWOL, a second-half rebound could come in later, and weaker, than hoped for. It's the Feel-Bad Recovery, in which growth exists, but at a level too anemic to reduce unemployment or stir up what John Maynard Keynes called businesses' "animal spirits." Says EMC Chief Executive Joseph M. Tucci: "The [weak] economy is still our public enemy number one."

But there's a risk that this year could turn out to be something worse than another case of disappointing déjà vu. That's because of that new danger lurking -- deflation. If deflation hits and prices and incomes start falling in tandem, the effect could be a troubling downward spiral: Profits will suffer, layoffs will increase, and consumers will retreat.

For now, Greenspan & Co. remain in the camp of optimists who still believe a full-fledged rebound will take hold in the second half. But Fed policymakers are worried enough about the nightmare scenario to signal that they're ready to cut interest rates further in June from their already meager 1.25%. That's a major shift for the Fed, which has spent the last quarter-century trying to tame inflation and contain price increases. Now, in the restrained language of the central bank, a substantial further fall in the inflation rate would be "unwelcome."

No one is comparing the relatively slight risk of deflation in the U.S. to the steady price erosion that has occurred in Japan, or to the downward spiral that U.S. prices suffered in the 1930s. Yet Fed policymakers are well aware that their Japanese counterparts made the fatal error of assuming that deflation couldn't happen there -- until they found themselves caught in a self-perpetuating downturn that they're still fighting. For the Fed, Japan offers a clear lesson: Don't wait for deflation to happen. Act aggressively to prevent it.

Deflation is a particular worry for the central bank because the traditional tool for spurring growth -- lowering short-term interest rates -- is useless in the face of falling prices. Typically, the Fed tries to combat slumps by trying to create so-called negative real interest rates -- rates below the level of inflation -- to induce skittish consumers and companies to spend more. But if inflation turns negative, that won't work. "The credibility of the Fed's commitment to containing inflation -- and its proven capacity to do so -- does not necessarily extend to deflation," Richmond (Va.) Fed President J. Alfred Broaddus Jr. said on Apr. 15.

That's why Greenspan & Co. aren't about to take any chances. With the central bank's favorite inflation gauge -- the personal consumption expenditure price index excluding food and energy costs -- running at a mere 1% over the past six months, it would take just one negative economic shock -- such as another terrorist strike -- to push the U.S. into deflation.

Greenspan is also worried that substantial further disinflation could pinch corporate profit margins and prompt a new round of cutbacks in business spending, which is just starting to revive. It also could throw a wrench into the stock market's nascent revival.

Business leaders can certainly sympathize with Greenspan's concerns. For many, particularly in manufacturing, price deflation is no theoretical concern. "It's a whole different environment," says 3M (MMM ) Co. Chief Financial Officer Patrick D. Campbell. "I can't think of an industry that's not performing under the constant pressure" of falling prices.

To many, the U.S. economic outlook might sound a lot like Japan Lite. But there is a big difference: productivity. Japan would love to have had the 2.1% economic growth the U.S. has experienced over the past year. Because Japanese productivity is so low, gross domestic product growth above 2% or so would mean a fall in unemployment. But that level of growth feels so paltry to the U.S. because it's so far below the economy's potential. Experts peg theunderlying growth of U.S. productivity at about 2% or 2 1/2%. After taking into account the 1% annual rise in the labor force, that means the economy needs to grow faster than 3 1/2% to bring down unemployment.

A period of sustained above-trend growth is also the only sure way to beat back the risk of deflation. That's because there's so much slack in the economy, especially in manufacturing, where capacity utilization is running at a 40-year low of just 73%. Until that slack is taken up by faster growth in demand, companies will be under pressure to slash prices to boost sales. So even if the economy grows at a 4% clip over the next year, Fed officials fret that it will be 2005 until the excess capacity is eliminated and the disinflationary bias blunted.

Of course, all the worrying about deflation could prove to be just so much hot air if the economy picks up strongly in the second half. And certainly, there are some hopeful signs. Oil prices have fallen 30% from their prewar highs, pumping up consumers' spending power. The stock market has risen nearly 15% from its lows, buoying investors' spirits. And the steep fall of the dollar -- it's down 6% against the euro in just the past month -- is a big plus, provided it doesn't turn into a rout. The drop is boosting import prices, relieving the downward price pressure in the U.S., and it's helping exporters boost their sales and profits.

The improvement in the profit picture is particularly encouraging. According to Thomson First Call, two-thirds of companies have reported first-quarter earnings so far, and the total earnings reported are about 7% over analysts' estimates for those companies. What's more, analysts have finally stopped slashing estimates for upcoming quarters, unlike the past two years when they were constantly revising down their estimates.

All well and fine. Yet improved profits are coming about mainly through cost-cutting. The combination of weak demand and virtually nonexistent pricing power has left companies with no choice. That's certainly the case at Cisco Systems (CSCO ) Inc. The San Jose (Calif.) technology industry bellwether reported on May 6 that profits for the quarter that ended on Apr. 26 jumped 35%, even though revenues slid 4%. Job cuts -- Cisco trimmed its workforce by 5%, or 2,000 people, in 2002 -- were a key reason for the improvement, and staff may continue to shrink. "We'll continue to focus on cost-cutting," CFO Larry Carter says.

Cisco is hardly alone. Since January, employers have slashed 525,000 jobs. That's fully a quarter of the jobs lost over the past two years. Part of that, of course, is the result of war worries, which depressed the economy for months. And payrolls should go back up once the 220,000 reservists called up for the war return. But the need to boost profits through belt-tightening will remain. "Because the recovery is so muted, companies are continuing to do surgery on their employment base," says Manpower (MAN ) Inc. CEO Jeffrey A. Joerres. "We're going to see at least another quarter of job losses."

The risk is that the rising jobless rate could put a crimp in consumer spending and stunt the upturn in the economy. That is already happening in the auto market, where a new round of hefty incentives is failing to stir up sales. Sales of cars and trucks fell 6% in April, to a seasonally adjusted annual rate of 16.5 million units, well below the 21.1 million sales rate in October, 2001, when 0% financing was introduced.

With the successful conclusion to the war, the U.S. appears to have dodged the danger of a double-dip recession. But it's far too soon to declare the all-clear for this economy.

By Rich Miller in Washington with Michael Arndt in Chicago, Faith Keenan in Boston, Christine Tierney in Detroit, and bureau reports

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