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The Current Macroeconomic Situation: The U.S.

(2002-01-28): 2001 saw the U.S. economy enter its first recession since the start of the 1990s. Throughout the year the economic situation deteriorated swiftly. By the end of 2000, industrial production was some six percent below what it had been at the end of 2000. Real GDP in 2001 averaged only one percent more than in 2000. Unemployment rose swiftly from near 4 percent at the end of 2000 to near 6 percent at the end of 2001. The fall in output and employment was accompanied by good news on the inflation front. Consumer prices that had been rising at a rate of 3 to 4 percent per year during 2000 rose by only 1.5 percent in all of 2001.

Howeer, by the end of 2001 there was a growing consensus that in all probability the recession was almost at an end. The terror attack on the World Trade Center on September 11 had not been followed by other, similar atrocities, and thus turned out to have a temporary rather than a permanent psychological effect on confidence. The Federal Reserve cut interest rates 11 times during 2001. Little of that reduction in interest rates has of yet fed through to affect the economy. Falling energy prices, an extraordinary amount of reduction in interest rates over 2001, substantial fiscal stimulus from military- and disaster-related spending, and the working-off of inventories in 2001 all seemed to leave the U.S. economy poised for a renewal of economic expansion in 2002.

The stock market agrees with economic forecasters: stock prices have recovered considerably from the low points they reached in the aftermath of the September 11 terror attack. Consumer confidence has strengthened. The Conference Board's index of leading indicators has recovered as well.

The average post-World War II recession in the United States has lasted for less than a year. The National Bureau of Economic Research has dated the beginning of this recession to March of 2001. On that calendar, it is a good bet that the current recession is almost over. Thus the forecast for economic growth in 2001 looks relatively bright.

(2001-10-20) As of the mid-fall of 2001, economists and economic forecasters were still grappling with the problem of assessing the impact of the September 11 terror attack on the World Trade Center that killed more than 5,000 people. The terror attack was a strong negative shock to business confidence, and thus to investment spending, and may (but may not) prove to have been a strong negative shock to consumer confidence, and thus to consumption spending. The forecasts that saw the U.S. economy attaining a "soft landing"--with unemployment kissing 5% early in 2002 and then starting to decline--has gone out the window. But there is, as yet, no consensus forecast to take its place.

In September 2001 American industrial production fell by one percent--bringing it to a level six percent below its year-2000 peak. In September 2001 American retail sales fell by 2.5%. The major effect of the terror attack has been to raise uncertainty. And when things become uncertain, both businesses and consumers hold off on major irreversible financial commitments: business investment and consumer purchases of durables are now falling. By how much? Nobody knows.

Most economists now predict that American GDP will show a total decline of about 1% through the third and fourth quarters of the year. They say it will be broadly flat in the first quarter of 2002, then start to recover, with relatively strong growth—say, 3-4%—by the second half of next year. If so, this would be one of the shortest and mildest recessions on record.

However, there are reasons to expect that America's current recession may be mild. First, oil prices have not risen, but fallen. Second, the American economy is about to benefit from stimulative monetary and fiscal policy. Because inflation has been low, the Federal Reserve has responded to the weakening economy in 2001 by cutting interest rates. They have been cut to their lowest levels since the early 1960s. The positive effect of the interest rate cuts beginning last winter is about to hit the economy.

Moreover, the administration has announced its support for an additional fiscal stimulus program (on top of the $45 billion disaster spending already set in motion) of up to $75 billion in 2002--$15 billion helping the unemployed, a one-time tax rebate for poorer Americans, and accelerating cuts in marginal income-tax rates. According to the Economist, the total fiscal stimulus in 2002 could amount to 1.5% of GDP—the largest one-year stimulative boost to fiscal policy in a generation.

But precisely because uncertainty is so great, it may well be the case that America's recession will be quite deep. Tax cuts that boost household income will have little effect on consumer spending if uncertainty remains high and consumer confidence collapses. Lower interest rates will not boost corporate investment in a climate of excess capacity and a desire by businesses to remain flexible and liquid in the face of high uncertainty. Consumer spending has been very high relative to household income for half a decade: it is hard to see how the future could hold rapid consumption growth in any scenario. Investment spending is also likely to decline steeply because of three factors: uncertainty created by the terror attack, the fact that businesses already have a lot of excess capacity, and the dependence of companies on the continuation of high internal cash flows--which are already coming to an end--to finance their investment.

Moreover, the rest of the world economy is weak as well. Japan is unlikely to emerge from recession in the next year or so. The European Central Bank continues--for some reason not clear to anybody else--to keep interest rates high out of fear of inflation. In Latin America Argentina is expected to default, Mexico is in recession, and Brazil is in recession. Falling exports have cut forecasts of East Asian growth in half. The U.S. economy was the "locomotive" pulling the world economy forward in the 1990s: it was the importer of last resort. But now the world economy has lost its locomotive, and there is no alternative source of high world demand in sight.

How fast will America's economic growth be after the recession ends? Productivity growth averaged 2.5% over 1995-2000, more than twice its pace of 19783-95.The consensus is that productivity growth was boosted by investment in information technology--even though not all of the investments in information technology in the 1990s were productive. Those sectors that experienced rapid productivity growth had high IT investment rates, but not all sectors that had high IT investment rates experienced rapid productivity growth. Almost all observers project productivity growth in the next decade to be at a rate of 2.0% per year or faster--closer to the growth rate of the past five years than to that of the previous generation.

(2001-05-30) As of the late spring of 2001, the United States macroeconomy seemed poised to continue its expansion, albeit at a slower pace than during the second half of the 1990s. The United States was still in the long expansion that had begun at the beginning of the 1990s--the longest business cycle expansion, the longest period of time without a recession, in history. Most observers expected real GDP in the United States economy to grow at about 1.5 percent in 2001--a pace that would see the unemployment rate rise a few tenths of a percentage point--and at about 3.0 percent in 2002.

The fears that had been common in the winter that the United States economy teetered on the brink of a recession were largely gone. The consensus of observers of the economy was that the Federal Reserve had overdone it and raised interest rates too far and too fast in late 1999 and 2000. But the Federal Reserve had swiftly and substantially lowered interest rates in the winter of 2001. The three-month money-market nominal interest rate that had been 6.74 percent per year in the summer of 2000 was 3.95 percent per year by the late spring of 2001, and further cuts were generally expected. Economists expected these Federal Reserve rate cuts to boost investment spending and growth by the end of 2001, or the beginning of 2002. Thus forecasters' central projections saw U.S. growth accelerating a bit in late 2001 as Federal Reserve interest rate cuts and front-loaded tax cuts began to have their effect on total spending.

The Federal Reserve had shown itself ready and anxious to take steps to fight any slowdown. The larger recessions of the post-World War II period had all come to pass because the Federal Reserve was more concerned with fighting inflation than with avoiding recession. In the winter of 2001, however, inflation continued to be less than 2 percent per year and was not seen as a threat by anyone.

The U.S. growth slowdown at the very end of 2000 had been preceded by a remarkable decade-long economic boom. Policymakers and economists advocating the Clinton deficit-reduction program in the early 1990s had claimed that deficit reduction would make possible a high-investment economic expansion, which would then become a high productivity growth expansion. Up until 1996 there had been no signs that high investment was leading to high productivity growth. But by the late summer of 1999 productivity growth had been strong for four years in a row. Perhaps political claims in the early 1990s that deficit reduction would ignite a high-investment and high-productivity growth recovery were coming true. Perhaps the U.S. economy was simply benefiting from the sudden wave of rapid productivity growth driven by the technological revolutions in data processing and data communications. More likely is that both possibilities were somewhat true, and that they reinforced each other--higher investment allowed businesses to more rapidly take advantage of technological advances in data processing and data communications.

In the United States the strong growth in production and sales in the second half of the 1990s had pushed the unemployment rate down to a level--four percent--not seen in a generation. A tight labor market was good news for workers: employers appeared eager to pour resources into training them for their jobs. Yet the tight labor market and the strong demand for employees was not showing up in strong real wage growth. This low inflation proved a puzzle to economists: practically all had confidently forecast (using their estimates of the Phillips Curve relationship between inflation and unemployment) that unemployment below 5 percent would surely lead to accelerating inflation. Yet it had not done so.

There are, however, two sources of weakness in the U.S. economy. First, the stock market remains very high, and there are fears (i) that the stock market may crash, and (ii) that a stock market crash would harm consumer confidence, reduce consumption spending, and send the economy into a recession. Thus the Federal Reserve has to maintain financial stability while not artificially boosting the stock market further. Second, the U.S. exchange rate--the value of foreign currency and goods--is low, which means that the value of the dollar is high. Should foreign exchange speculators lose confidence in the dollar, the value of foreign currency could rise far and fast, possibly causing macroeconomic problems.

Economists are very good at pointing out economic situations that are inconsistent with fundamental values--policies, imbalances or balance sheet problems such that they cannot possibly last, and are bound to end, perhaps in a crisis. The value of the stock market and the value of the exchange rate as of the late spring of 2001 appear at odds with fundamentals, and possible sources of financial crises in the future. But, as economist Rudiger Dornbusch was written, "to get to the crisis takes longer than you think, and then it happens faster than you would have thought."

(2001-03-01) As of the winter of 2001, the United States macroeconomy teetered on the brink of a recession. The consensus of observers of the economy was that the Federal Reserve had overdone it and raised interest rates too far too fast in late 1999 and 2000. Thus by the start of 2001 economic growth in the United States had slowed to a very weak pace. The consensus forecast was that the year 2001 would see U.S. real GDP grow by no more than 1.8%, and a recession--an absolute fall in real GDP for two quarters--was a definite possibility.

The Federal Reserve reacted to the bad economic news over the winter of 2001 by sharply and rapidly lowering interest rates. But Federal Reserve policies affect the economy only with significant lags. Reductions in interest rates at the start of 2001 would not have any noticeable effect on the economy until the very end of the year. And the tax cuts proposed by the new President, George W. Bush, would take even longer to affect production and employment.

As Americans contemplated the prospect of a recession, the bright spot was that the Federal Reserve was ready and anxious to take steps to fight any slowdown. The larger recessions of the post-World War II period had all come to pass because the Federal Reserve was more concerned with fighting inflation than with avoiding recession. In the winter of 2001, however, inflation continued to be less than 2 percent per year and was not seen as a threat by anyone.

The slowdown at the very end of 2000 had been preceded by a remarkable decade-long economic boom. Policymakers and economists advocating the Clinton deficit-reduction program in the early 1990s had claimed that deficit reduction would make possible a high-investment economic expansion, which would then become a high productivity growth expansion. Up until 1996 there had been no signs that high investment was leading to high productivity growth. But by the late summer of 1999 productivity growth had been strong for four years in a row. Perhaps political claims in the early 1990s that deficit reduction would ignite a high-investment and high-productivity growth recovery were coming true. Perhaps the U.S. economy was simply benefiting from the sudden wave of rapid productivity growth driven by the technological revolutions in data processing and data communications.

In the United States the strong growth in production and sales in the second half of the 1990s had pushed the unemployment rate down to a level—four percent--not seen in a generation. A tight labor market was good news for workers: employers appeared eager to pour resources into training them for their jobs. Yet the tight labor market and the strong demand for employees was not showing up in strong real wage growth. Real wages in the year up through December 1999 had grown at only 1.9 percent. On the other hand, relatively slow nominal wage growth meant that inflation remained low as well.

This low inflation proved a puzzle to economists: practically all had confidently forecast (using their estimates of the Phillips Curve relationship between inflation and unemployment) that unemployment below 5 percent would surely lead to accelerating inflation. Yet it had not done so.

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