You Hoped for a Slowdown?
Be Careful What You Wish For

For the U.S. economy, the millennium year came in like a lion but is going out like a lamb. A combination of interest rate hikes, rising energy prices, tighter credit standards and sharp declines in equity markets has finally taken the bloom off the U.S. economy. Higher interest rates and energy prices have impacted household budgets, but probably the biggest factor contributing to the slowdown is the unnerving plunge in equity prices. The Wilshire 5000 is down 20% from its spring peak, which translates into a loss of about $3 trillion in shareholder wealth. Barring a rally early in 2001, the reverse "wealth effect" associated with falling equity prices will likely trim consumer spending plans somewhat over the next year. Still, the biggest drag at the moment seems to be psychological: business and consumer confidence is slipping as Wall Street woes continue to dominate the financial news.

A quick roundup of current statistics explains why the Federal Reserve Board stated on December 19th that it has shifted from worrying about an overheated economy to a belief that "the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future."

• Personal incomes fell 0.2 percent in October, the first drop in over 2 years.
• Gross Domestic Product (GDP) growth during the third quarter was 2.4%, the slowest pace in 4 years and less than half the growth rate for the same period in 1999.
• Inflation remained tame as prices increased just 1.9% in the third quarter, down from a 2.4% pace in the second quarter.
• Rising unemployment claims are prompting many economists to forecast an upturn in the unemployment rate, from its current 3.9% to perhaps 4.5% by next summer. Although still quite good by historical standards, the rise translates into loss of about 845,000 jobs.

A slide into recession is by no means inevitable. Although the Fed left short-term interest rates unchanged at its December meeting, it clearly signaled an inclination to ease at signs of further slowing. A rate cut as early as January is increasingly anticipated by the financial markets. Moreover, the tax cuts proposed by President-elect George W. Bush during the campaign which seemed to many economists totally inappropriate last summer when growth was hot and inflation was rising are starting to look like a good idea. So, in sharp contrast to the policy environment 6 months ago, a simultaneous easing of both monetary and fiscal policy has become more likely, which should prevent a hard landing. Still, there is no question that the risk of recession is greater now than at any time in the past decade.