Recession Can Still Be Avoided But Plunging Confidence is Dampening Growth

The latest (February) survey of professional forecasters conducted by Blue Chip Economic Indicators found that only 5% thought the U.S. economy was currently in a recession, but the panel has sharply reduced their growth forecasts for 2001from 3.6% in October to 2.6% in January to 2.1% by the latest survey. The consensus forecast for growth in the first quarter of 2001 was just 0.8%. The last time the consensus forecasts fell so much over a four month period was in the summer and fall of 1990, also the last time the U.S. economy slipped into recession.

There seems to be evidence to support both the optimists and pessimists these days. Statistics released in mid-February on housing starts and manufacturing activity showed a slight rebound in January. But, both of the closely watched indices of consumer confidence have revealed an alarming plunge over the past two months. The University of Michigan's Index of Consumer Sentiment fell to 87.8 in early February, its lowest level since 1993 and sharply lower than the levels recorded as recently as last November. Interestingly, the gap between consumers assessment of current conditions (generally more positive) and their expectations for the future (pessimistic) is the largest ever recorded in the Michigan survey. In summing up the forces dominating the economy at the moment, reporters Greg Ip and Russell Gold of The Wall Street Journal paraphrased Franklin Roosevelt in saying "What the economy has to fear most, it seems, is fear itself."

So, perhaps the slowdown is more imagined than real? Don't put too much stock in that explanation warn Goldman Sachs economists William Dudley and Ed McKelvey. It is true that several unfavorable and temporary factors simultaneously imposed a drag on growth during the fourth quarter (and into 2001). Unusually cold weather depressed consumer spending during November and December, and also compounded the impact of higher natural gas prices on household budgets. These effects will quickly pass as the weather warms this spring. However, the more fundamental problem is that we are coming off a prolonged boom period in which consumption rose faster than income and investment spending increased as a percent of Gross Domestic Product. Neither trend could be sustained indefinitely and both appear to be winding down. "The question is whether this will be followed by an outright bust as businesses and households retrench."

How will they retrench? Dudley and McKelvey observe that the vaunted wealth effect will begin to reverse. The ratio of household net worth to disposable income, which rose through most of the past 6 years with the boom in equity markets, has now begun to decline. When consumers felt wealthier (relative to their incomes) they saved less and spent more. The savings rate fell steadily beginning in 1995, culminating in a negative savings rate by 1999. But, with the sharp declines in equity prices last year, net worth is smaller now relative to income and some rise in the saving rate seems inevitable. For that to occur, consumer spending has to grow more slowly than disposable income. Consequently, "the household sector will act as a drag on overall economic activity."

As for the investment side, capital is harder to obtain than it was a year ago at the height of the NASDAQ boom. Plus, the long-running investment boom has expanded capacity sufficiently that the capacity utilization rate has been falling rapidly. Historically, this has been a leading indicator of a slowdown in business fixed investment.

If both consumption and investment spending cool, then recession risks rise substantially. Goldman Sachs puts the recession odds for 2001 at 1 in 3. Equally important, they do not subscribe to the optimistic view of many analysts that we will enjoy a rapid rebound if policymakers can just revive consumer confidence and move us past the temporary drag imposed by bad weather and high fuel prices. In other words, neither monetary or fiscal policy will re-ignite the boom. Three reasons moderate their outlook for the remainder of this year:

• Interest rate-sensitive sectors (like housing) will not provide much support for a strong rebound. Unlike past slowdowns, they were not depressed when the Fed began to cut rates, so don't need to be revived.
• Lower interest rates can prevent a further downward spiral but will not do much to reverse the rising saving rate or rekindle another investment boom. Barring a large rise in stock prices, neither the consumption nor investment booms are likely to be quickly restarted.
  Fiscal stimulus in the form of tax cuts will work very slowly. If it happens, a tax cut is not likely before summer and past experience indicates that much of the first year's tax cut is saved. Consequently, don't expect a boost to this year's economic growth from tax cuts.