From Soft to "Rocky" Landing:
The Economy Goes from Great to Near Recession in a Few Short Months

The Fed cut interest rates three times in the first quarter of 2001 for a total move in the Fed funds rate of 150 basis points (1 ½ percentage points). Such an event is almost unheard of in the annals of Fed history and is especially surprising given that Mr. Greenspan is known to be a gradualist of the highest order. The Fed’s latest 50 basis point move on March 20 brings the Fed funds target rate to 5%, a rate just 25 basis points above the level that existed prior to the beginning of the last round of Fed tightening back in 1999. The discount rate was lowered to 4.5%, exactly the same level that prevailed in 1999.

In addition, the Fed’s statements accompanying the most recent rate moves acknowledged both the condition of the equity market and the seemingly deteriorating economic conditions in many overseas countries. This realistic assessment of both the global economic situation and the increased importance of common stocks in assessing the wealth and health of U.S. household financial statements stood out in contrast to the narrower approach taken by the Fed in its February meeting. These statements and the Fed’s existing bias toward ease, gives rise to the belief that the U.S. central monetary body stands willing to engineer an inter-meeting rate cut if it becomes necessary.

Simultaneously, money supply growth over the past four months or so is approaching 20%. It is clear, therefore, that the Fed is worried that the current softness in the U.S. economy could readily descend into a recession.

How did the economy go from great to near recession in a few short months?

First of all, as we outlined last quarter, the Fed raised interest rates six times in the twelve months ending June 2000 which had the effect of bringing the 6% annual U.S. GDP run rate that existed in June of 2000 down to under 1% by December 2000. The simultaneous tightening of bank credit standards raised concern about bank asset quality and the flat level of lending in last year’s fourth quarter helped limit the economy’s ability to expand.

Secondly, U.S. corporations’ multi-year capital spending boom came to a halt. After peaking at a 16% compound annual growth rate in the first quarter of 2000, business investment declined 3.5% in the fourth quarter of 2000. Furthermore, a quick pickup in capital investment is not likely because three categories of major capital spenders are facing unprecedented difficulties. First of all, dot com companies made major capital investments in the past few years but many are now quite simply going out of business. Another major segment of recent capital spenders, the various telecommunications sector industries, is in chaos. Secondly, excess capacity exists in many product lines and others are subject to increasing commoditization (that is, so standardized that they are mass produced and distributed in bulk). Companies with nearly $40 billion in revenue two years ago are being mentioned as bankruptcy candidates (Lucent Technologies). The rest of corporate America is likely to reign-in capital investment over the near term as most are dealing with eroding margins, falling utilization and increasing debt levels.

Third, there was a buildup of inventory, centered primarily in technology industries. The so-called “inventory correction” began in the fourth quarter and is proceeding quickly. Inventories contracted substantially in February, at both the manufacturing and wholesale levels, and are taking at least half a percentage point away from already slow first half GDP growth. Most of the remaining excess inventory should be worked through by June.

Finally, there is a slowdown (which we believe will prove temporary) in the demand for technology-based products. At present, Europe appears saturated with wireless handsets and the U.S., while it hasn’t yet experienced Europe’s penetration for these devices, is going through softness as well. We believe this market needs third generation instruments to add a fillip to demand. Certainly, that is true of the next generation of Palm Pilots and Research in Motion’s Blackberry. The much vaunted slowdown in the purchase of personal computers also awaits a new product cycle. In consumer electronics, government red tape has slowed introduction of such potentially desirable items as high definition television while flat panel displays probably need lower price points to stimulate demand. The implementation of broadband in the home is still awaiting full buildout, a process that has been curtailed in the current slowdown.

In summary, the slowdown was caused by over spending in the industrial sector which, when combined with an inventory correction, with the temporary stalling of demand in certain industries and with Fed rate increases last year, brought the economy to a halt rather quickly.

Furthermore, the industrial sector continues to be weak. The Chicago Purchasing Managers’ Survey (an index of industrial activity) declined sharply in March, registering a 35.0 reading, down from 43.2 in February. This is the sixth consecutive monthly reading below the neutral 50.0 level and was its lowest reading since 1982.

Fortunately for the domestic economy, consumer spending, which continues to represent two-thirds of U.S. GDP, has been quite good. Personal income was up 0.5% in January and 0.4% in February and consumption expenditures rose 3.5% above year ago levels. While this is a sharply slower consumer spending growth rate than was the case in early 2000 it is still comfortably up. Consumer credit continues to grow at a 10% annual rate, up from 4%, which is worrisome. However, consumer debt service as a percentage of disposable income is just above 14%, somewhat below the highs attained in the second quarter of 1986 yet also below levels that have precipitated reliquification (debt paydown) in the past. In the absence of huge increases in unemployment it is unlikely that consumer spending will collapse this year.

It appears that the economy is most likely at its softest level right now and that first quarter GDP will range from 0 to 0.5%. At those numbers there is little room for error though and it is possible GDP could turn negative in the first quarter. Should the inventory slowdown continue past June and capital spending not resume later this year we could actually have negative GDP in the second quarter as well, especially if layoffs force the consumer to stop spending. However, in such a circumstance, the policy responses would be quick and significant and any recession that ensued would probably be limited to a two or three quarter event. We put the chance of a recession at 20%, admittedly not an insignificant number, but we also continue to believe it will be avoided.

We expect that the first quarter will prove to be the worst of this year and project that each successive quarter of 2001 will improve. The net result will see GDP for 2001 up 2.0%. Inflation is being held in check by a flood of imports and by low domestic capacity utilization. We expect price levels to be up no more than 2.0% this year. Thus, the landing will prove to have been neither soft nor hard but, instead, perhaps “rocky,” or near recessionary.