On the Brink of a Downturn

Despite the best efforts of the Federal Reserve, the economy seems to be teetering on the edge of recession. Five times this year the Fed has lowered its short-term interest rate targets, most recently on May 15th. The previous four efforts were not sufficient to reverse either a deteriorating business outlook or the curtailment of plans for investing in new plants and equipment. With this fifth cut and the companion statement that it believes the downside risks are still significant, the Fed hopes to signal the gravity of the current outlook and convince the bond markets that long-term rates are too high.

Goldman Sachs economists William Dudley and Ed McKelvey do not share the optimism of some analysts that growth will rebound in the second half of this year, and their alarm seems to mirror the thinking behind the Federal Reserve's statement accompanying the latest interest rate cut. The combined effects of an investment bust and tapped out consumers are imposing a drag on spending, which is threatening to create a vicious, reinforcing cycle of declining output, employment and further spending cutbacks. The warning signals are as follows.

1. The U.S. economy is experiencing an investment spending bust. Declining profits have spurred companies to pull back on spending plans for new plant and equipment. The effect was first seen a year ago in the manufacturing sector and is now most evident in the technology sector, especially in telecommunications firms. Through the first quarter, 2001, both orders and shipments in the technology sector had declined by 20% on a quarter-over quarter basis, the direct result of the economy-wide pullback in technology investment. Widespread revenue shortfalls have been reported by major technology companies, relative to their earlier estimates. Share prices have fallen accordingly and layoff announcements have become more frequent. None of this is good news for economy-wide growth prospects.

2. The cutback in business investment does not bode well for households' financial prospects. The unemployment rate has risen from 3.9% as recently as last October to 4.5% in April 2001. In particular, the net loss of 223,000 jobs in April was the largest one-month decline in employment since February 1991, in the middle of the last recession. Until now, the slowdown in U.S. economic growth had been largely a result of reduced corporate spending on plant and equipment. But as the malaise spreads from manufacturing and technology sectors into the service sectors, the danger is that rising unemployment will dampen consumer confidence and trigger further slowing in household spending. Goldman Sachs economist William Dudley told the New York Times "The risk is that we are going to get caught in a vicious circle, with rising unemployment leading to cutbacks in spending which lead to further job losses."

3. The negative wealth effect has yet to work its way through the economy and will likely prove to be a significant drag on consumer spending, unless incomes show strong growth over the coming quarters. The household saving rate is exceptionally low given the sharp decline in the ratio of household net worth to disposable income over the past 12 months. Although equity values have risen in recent weeks, net worth remains far below where it was in early 2000. The current household saving rate is -1.0%, a full 3 percentage points below where Goldman Sachs forecasting models estimate it should be given the current net worth/disposable income ratio. The savings gap is the largest in the last 50 years for which data exist. With the current saving rate so far below the equilibrium (sustainable) rate, consumers appear poised to adjust their spending plans downward.

4. Signs of household financial stress have been flashing for several months, and will likely impose an additional drag on spending. Rather than signaling optimism and spending exuberance, the rapid growth of consumer installment credit through February suggested distress. The economic researchers at Goldman Sachs have found that when consumer credit growth accelerates at the same time that real disposable income and consumer confidence is weakening, as has been the case since last fall, it foreshadows a pullback in consumer spending. The surprisingly strong growth in consumer spending (3.1% annualized rate) during the first quarter, 2001 was deceptive, since most of the strength was registered in January. Real consumer spending skidded through February and March and vehicle sales in particular weakened during April. The Federal Reserve Board reported that consumer installment credit slowed sharply in March as well, rising at only a 4.7% seasonally adjusted annual pace, the slowest pace in 17 months. Even more worrisome is the continued rise in loan delinquencies, chargeoffs and personal bankruptcies (see related article later in this section).

Recession is not a foregone conclusion, but the probability at the moment is higher than at any time in the past 6 months. The labor market will be the bellweather. If layoffs continue and unemployment rises steadily, Dudley and McKelvey expect households to adjust quickly to the more conservative pattern of higher saving and lower spending that the models anticipate. If labor markets stabilize as the Fed's accomodating monetary policy steadies the nerves of investors and revives corporate spending plans, then income growth may strengthen and the savings adjustment may occur gradually.

Highlights from the most recent Goldman Sachs forecasts follow (as of May 4, 2001):

• Expect real GDP growth the remainder of this year to be between 1 and 2%. For 2002, expect 2.5% real growth.

• Unemployment will rise to 5% by early 2002. This is largely because the potential (non-inflationary) growth is about 3%, given the productivity gains of the past decade. Consequently, the forecast for subpar 1-2% actual growth in the coming quarters will inevitably lead to a rise in joblessness.

• Inflation fears have eased with the weakening economy. Rising gasoline and energy prices will keep the 2001 inflation rate around 3%, but expect price pressures to abate in 2002, with about a 2% rise in the Consumer Price Index.

• Corporate profits will likely fall slightly during the balance of 2001 (expect about a 2% decline for the year) before starting to rise again in 2002. Consequently, expect further turbulence in the equity markets, with no strong upward trend this year.

• The Fed will likely continue cutting short-term rates by an additional 50 basis points before the end of the summer.