Moving Ahead - To Recession?
The Wealth Effect and the Peace Dividend Both Disappear at Once
The U.S. economy was very near recession during the weeks prior to the attacks on September 11th. Industrial production, retail sales, chain-store sales and consumer confidence had all been reported weaker than estimated. The University of Michigan consumer sentiment numbers for September were released a couple of days after the attacks and reported the lowest readings since 1993. Expectations were down from 85.2 to 77.2 which is especially troubling since a slide in that segment of the sentiment report portends additional curtailment of consumer spending in the coming months, a period when consumer spending was supposed to be propping up the domestic economy. Finally, second quarter Gross Domestic Product (“GDP”), after revisions, is +0.3%, barely avoiding negative territory.
Once the terrorist attacks occurred, the already fragile state of the U.S. economy moved swiftly toward outright recession. The third quarter (just ended) is now estimated to show a real decline in GDP of at least –1.0% and the fourth quarter is likely to decline as well, despite the substantial positive impetus it will receive from aggressive Fed easing. Simultaneously, the unemployment rate will be rising from its present 4.9% level to around 5.7%. Initial unemployment claims are sure to move higher, in view of layoffs recently announced in the leisure and entertainment industries, as well as those in the airline industry.
The policy responses in the wake of the terrorist attacks have been swift, decisive and impressive. Nothing more accurately characterizes the magnificence of the Fed during this crisis than the press release it issued on September 11th: “The Federal Reserve System is open and operating. The discount window is available to meet liquidity needs.” And meet them it did. Absolutely massive amounts of liquidity were injected into a system which was already carrying historically high levels. In addition, the Fed has lowered interest rates twice since the attacks, totaling 100 basis points (one percentage point) in both the Fed funds rate and the discount rate. This brings the total reduction in the Fed funds rate to 400 basis points (four percentage points) in nine instances of Fed action in just nine months and leaves the target Fed funds rate at 2.5%, the lowest that rate has been since John F. Kennedy was President.
The Fed has also announced additional swap facilities with foreign banks, an arrangement designed to ensure that U.S. dollars are available to settle transactions. Such Fed moves, in concert with its posture on interest rates and substantial cooperation from other agencies, such as the SEC’s more relaxed stock buyback rules, have successfully averted what could have been a serious panic situation.
Two months ago, the Congressional Budget Office estimated that the fiscal 2002 budget surplus would be around $175 billion. It now appears that this surplus will be eliminated, perhaps entirely. The estimate assumed $50 billion in tax collections that will disappear as the recession reduces corporate income and delays acquisitions that would have caused sellers to pay capital gains taxes. Non-military new policy initiatives, such as aid packages to New York, potential Federal involvement in airport security, legislation attendant to bailing out the airlines and the Federal Air Marshal Program, will reduce the surplus by another $90 billion. This leaves $35 billion in surplus to spend on the war on terrorism, a number very likely to be exceeded. Thus, the budget surplus will become a budget deficit in short order.
Inflation pressures will move lower in the coming year, especially in the service sector. The most recently reported Producer Price Index showed a zero year over year increase, implying that the run rate of inflation, as measured by the Consumer Price Index should be under 2.0% next year. An absence of price inflation allows the Fed plenty of room to ease interest rates further.
Oil represents the wild card in our benign inflation scenario. Oil prices peaked at $36/barrel a year ago and today have moved to under $20/barrel, nearly a 50% decline. Should an extended, traditional ground war be fought or should some other supply interruption occur, oil would move upward again, worsening the inflation situation and potentially limiting the flexibility of the Fed.
As mentioned above, we believe that both the third and fourth quarters of 2001 will show GDP down 1.0% and that 2001 will end the year up modestly, probably about 1.0%. For 2002, we expect that the recessionary environment will impact the first quarter with the effects of the massive stimulus beginning to be felt by the second quarter of 2002. A complete recovery will build a head of steam by the second half of the year bringing full year 2002 GDP up in excess of 3.0%.
In 1991, the U.S. economy had just concluded the Gulf War and, with the fall of the Berlin Wall late in the prior decade, the last vestiges of the Cold War disappeared. Thanks to the Fed and the 1991 recession, inflation fell by 50% at the same time as defense expenditures were turning down as well. This so-called “peace dividend” allowed for an unprecedented period of private investment and budget surpluses culminating with the period of excess Internet investment which concluded in early 2000. As the Internet bubble burst, excess investment became a thing of the past and stock prices turned down with a vengeance. Thus, the “wealth effect,” to which Chairman Greenspan has repeatedly alluded, has now all but disappeared.
The “peace dividend” too is now likely to disappear. The process of fighting an unusual, extended and frustrating war and simultaneous expenses for extra domestic security all place the public sector in competition with the private sector for investment dollars, sounding the death knell for the peace dividend.
The result to the marketplace of losing the twin benefits of a peace dividend and the wealth effect is likely to be lower productivity and a slower-than-forecast economic recovery in the near term. Longer term, the benefits to the economy of wining the war on terrorism, such as growth and productivity increases as well as the lowering of the equity risk premium, are substantial bonuses to the primary goal of reclaiming our safety.
