Signs of Recession Loom Large

Do the tea leaves used by professional forecasters look that much different today than they did back in November? Well, yes, according to Goldman Sachs economists William Dudley and Ed McKelvey. They believe that the probability of recession has risen dramatically in the past 45 days, although it is not a foregone conclusion. Consider the following:

• The University of Michigan's Index of Consumer Sentiment plunged to 98.4 in December 2000 from 107.6 in November. The 9 point drop was the fourth largest decline since the monthly surveys were begun in 1978 (prior to that the surveys had been conducted quarterly). Ominously, the three larger declines all sparked recessions in the 1980s and early 1990s. The Director of the Michigan Survey, Richard Curtin, notes that the prior declines followed significant political events: President Carter's televised appeal to stop using credit in March 1980 (in an ill-conceived attempt to stifle inflation) and the Iraqi invasion of Kuwait in August, 1990. Some observers attributed the December, 2000 decline to the Presidential election stalemate, but Curtin found no evidence of that in survey responses. Rather, this time the plunge in confidence seems uniquely attributable to economic news. Consumers cited falling stock prices and news of the sharp slowdown in the pace of economic growth as the key developments. Even after the plunge, the Index remained just above the best year of the 1980s. Still, the data clearly indicate strong downward momentum. The Fed's interest rate cut in early January, 2001 will likely help, although not because it will ease debt burdens. Rather, Curtin emphasizes that the key issue is whether consumers will be assured that their future job and income prospects will benefit from stronger economic growth as a result of the Fed's actions.

  As of this writing the details of the January edition of the Michigan survey are not yet available, but a preliminary release indicated an additional drop to 93.6 from the 98.4 level recorded in the December survey. The Wall Street Journal reported that the decline "exceeded market expectations and marks the index's lowest level since the Asian financial crisis of 1997-98." The December decline had already played a significant role in Ford Motor's scale back of first-quarter 2001 North American production, according to George Pipas, Ford's sales analysis manager. Commenting on the preliminary release of the January survey, Pipas told The Wall Street Journal, "It confirms to us that the action that we took in December was appropriate."

• Demand for labor appears to be softening, especially in the manufacturing sector. Dudley and McKelvey note that layoffs in manufacturing have pushed claims for unemployment insurance up more than 80,000 since mid-April, an increase comparable to the initial stages of prior recessions. Coupled with the plunge in consumer confidence, these two factors are worrisome because they signal the beginning of a self-reinforcing dynamic. "By aggravating the deceleration already underway in household and business spending, they could transform what otherwise might have been a healthy deceleration to sustainable growth into something much weaker, including the possibility of an outright contraction."

• The wealth effect which has boosted consumer spending over the past 4 years seems to have dissipated and may even be turning into a drag on real spending. Personal saving out of income was torpedoed by the dramatic rise in equity prices during the latter half of the 1990s. As consumer net worth grew, the need to save out of income declined. All that changed in the second half of 2000. Dudley and McKelvey estimate that the decline in net worth between the first quarter of 2000 and the year's end was sufficient to raise the personal saving rate about one full percentage point in early 2001, unless share prices rebound sharply. A boost in the savings rate wouldn't be a problem if personal incomes continued to grow in excess of a 3% rate, as we witnessed over the past three years. But, with growth in output and incomes slowing, the renewed need to save will compound the drag imposed by declining confidence and slower job growth.

• As if all this weren't enough, skyrocketing natural gas prices have imposed an additional and unexpected drag on economic performance. This effect will be temporary, lasting only until the spring thaw, but in the meantime it is imposing a substantial burden on monthly household budgets. U.S. households normally spend about $35 billion per year on natural gas, mostly for home heating during the winter. It appears that natural gas prices this winter will average about 70%-80% higher than last year. Electricity prices will also rise because natural gas is a key raw material for power generation in many areas. The combination of the two factors will likely boost the Consumer Price Index by half a percentage point between now and April, 2001. Consequently, real disposable income will drop by about $20 billion, relative to last year. Consumers will dip into savings to cover some of the extra expense. Reductions in spending will account for the rest. Dudley and McKelvey argue that "if spending absorbs just one-half the impact, real consumer spending growth in the first quarter could be reduced by as much as 1.5 percentage points."