Economic Outlook
A Balanced Scale?

We could envision the measure of the economy’s health (the Gross Domestic Product (GDP)) and other economic factors as the unknown weights on an equal arm balanced scale. To use an equal arm balanced scale, objects of unknown weight are placed on one of the pans, and objects of known weight are placed on the other until the bar holding the pans is in balance. The Federal Reserve, led by Chairman Alan Greenspan, continuously monitors this economic scale, and judiciously uses its counterweights of adjusting the legally required reserve requirements for banks, buying or selling US government debt, and setting the Fed’s discount rate to attempt to maintain long-term sustainable growth.

When the economy is fully employed (generally considered to be when the unemployment rate is around 5.0%) real GDP growth (that is, adjusted for inflation) of 2.5% has traditionally been considered to be the long-term achievable growth rate. This range is determined by adding the historical population growth of 1.0% and the historical productivity improvement of 1.5%. Recent technological advancements, however, have led to significantly improved productivity, which in turn has led Chairman Greenspan and others to conclude that 3.0% to 3.5% may be the new long-term achievable growth rate.

After years of productivity drought, the floodgates have indeed burst open. The statistics show the US economy is awash in productivity gains, with an astounding 4.6% annualized rise in output per hour since the start of the recession in March, 2001, far outpacing the 1.8% productivity growth of the previous recession and recovery in the early 1990s. These gains have taken their toll on jobs for Americans, but have at the same time generated real benefits. The rapid growth in productivity over the past three years has added an additional $320 billion to the nation’s GDP compared to what the GDP would have been had productivity gains followed the slower pace of the previous business cycle.

As shown in the chart above, the benefits of productivity gains have shown up primarily in corporate profits. With the first-quarter earnings season upon us, Oakwood’s analysts expect profits of companies in the S&P 500 Index to increase 16.7% from the previous year. One recent plus for profits is the dollar’s decline, but that is far from the most important factor. Fourth-quarter net receipts from non-US operations were up 23% from the year before, but earnings from US domestic operations alone rose by a larger 30%. Profits are flowing, mainly because demand is accelerating at the same time that businesses are able to cut costs. During the past year, overall demand has grown 4.4%, more than double the 1.8% pace the year before. At the same time, productivity growth has reduced labor costs, the result of which is more of each sales dollar going straight to the bottom line.

The final revision of the fourth quarter 2003 GDP indicates economic growth increased by 4.1%, which was below analyst expectations but still considered strong growth. We expect first quarter 2004 GDP growth to be in the 4.5% range. As consumption (that is, consumer spending) comprises approximately 68% of the GDP, it is considered the most important component. Higher gasoline prices and other energy prices are behaving like a pseudo-tax on both consumers and businesses, threatening the recovery’s longevity. With crude oil quotes up 10-15% since December, the filtering effect to gasoline and other energy prices, along with a combination of low inventories, tight domestic refining capacity, stringent environmental requirements and stronger demand as we enter the summer driving season could drive prices up to new records. Based on the assumption that nationwide gasoline prices hit $1.95/gallon, up from the $1.74/gallon at the end of March, the consumer will face a pseudo-tax hike in the first half of 2004 of approximately $20 billion. Put more simply, each $0.01 rise in gas prices takes approximately $1 billion directly out of consumers’ pockets.

To be sure, rising tax refunds and other tax reductions will offset the impact of this scenario. The estimate for the retroactive features of last year’s tax cuts should reduce individual taxes by approximately $37 billion between February and May of 2004. Tax cuts and low interest rates are typically government responses when the economy is in need of help. What makes the current policy somewhat extraordinary is the aggressiveness of both the Bush administration and the Federal Reserve. The Federal Reserve has been busy over the past few months, decreasing the counterweight of the discount rate in the attempt to keep the recession shallow. The federal funds rate remains at 1%, after hitting a 46-year low nine months ago.

Further envisioning a mini-balance scale with inflation in one pan and deflation in the other, we recall that since the Federal Reserve began its interest rate cuts from the 6.5% rate at the beginning of 2001, these two pans have been undulating. Now we are seeing the factors between the forces that promote lower and higher inflation tilting toward the latter. Most prominently, “core” consumer prices rose by 0.2% for the second month in a row and by 1.7% at an annual rate over the past three months. This is a change from the November 2003 report of flat core consumer prices for the first time in more than four years. This change in pricing power is showing up in goods prices first. Core consumer goods prices, accounting for about 23% of the CPI, rose 0.3% in the past three months – a tiny change when looked at in isolation, but when compared to the 2.5% decline over the past year, not so tiny. As well, inflation in other forms, such as higher commercial insurance and health care costs, is filtering its way into the economy.

This evidence of the return of inflation isn’t ironclad, but outward signs are accumulating that point in that direction:

• Cyclical prices are booming. The prices that US companies pay for nonenergy commodities have increased 7-40% in the past year. This is shaping price expectations among manufacturers and some are passing through these increased costs.

• Inflation expectations are rising. The University of Michigan’s consumer polling indicates both one- and five-year expectations have risen. Consumer inflation expectations are important because they often anticipate measured inflation changes and because they also reflect behavior, especially in the wage-setting process.

• The long slide in the dollar has begun to slowly but significantly lift import prices. While US prices of Asian imports fell by 1.9% over the past year, this accounts for just 12% of the US total. On the other hand, the prices of imported goods from the European Union (EU) which account for 21% of US imports, have risen by 3.5% over the past year, thanks to a 15% depreciation of the dollar against the euro.

We have not achieved equilibrium in our disinflation-inflation scale, as neither the data nor analytics yet point uniformly to higher inflation. Unit labor costs are still falling, and there is ample slack in the US and global economies. However, as labor markets firm, unit labor costs will rise, as compensation mildly accelerates. The most recently released employment report astounded Wall Street with the reported addition of 308,000 jobs in March, with January and February numbers revised upward as well, strengthening the precept of a firming labor market. These employment numbers took many observers by surprise, but seem to be the missing counterweight for our growth scale, finally aligning with other economic indicators that have been signaling robust economic growth.

Consumers will remain the key to the recovery’s stamina, who by all measures seem to have the wherewithal to keep spending. Higher than usual tax refunds are starting to boost after tax income, and mortgage rates were recently back to near-record lows, which should add another lift to refinance money. These two factors, coupled with the good news in the labor market, should in turn boost consumer confidence. However, the economy is at an inflection point as new forces are acting upon it. Outsourcing looms as a potential threat because no one knows how many jobs and which industries are vulnerable. Productivity is problematic because the lines between the pros and cons are blurred. Meanwhile, the next revolution that is supposed to propel the economy and job growth forward after the Internet boom isn’t obvious.

The US is now experiencing the brunt of pain from outmoded jobs while still awaiting the innovations that will generate the jobs of the future. History has shown us, however, time and time again, that jobs follow growth, but not necessarily in a linear fashion. The US economy is and always has been an innovative economy. With the economic scales nearing a balance needed for sustainable growth, we feel the economy will deliver the jobs and prosperity that it has in the past.