Economic Outlook for 1999

Several key sectors of the U.S. economy have weakened during 1998, and others are likely to weaken in the near future.

• Exports are declining rapidly (See Figure 1).
• While imports have held steady, they appear ready for a surge. A surge in imports would cut into the production and profits of U.S. firms in industries that compete for imports.
• Consumption has remained strong, but a recent collapse in the saving rate suggests that the strength in consumption could be short-lived (See Figure 2).
• Capital investment, too, has remained strong. But the demands for structures and equipment is weakening in many industries due to declining prices and profitability. And the decline in export sales is reducing the need for producers to expand capacity (See Figure 3).
• The only sector that looks significantly stronger today than a year ago is residential construction (See Figure 4). Housing demand is being fed by record low interest rates, by record levels of confidence, and by the strong stock market. Of these only low interest rates can be expected to continue to add strength to housing in 1999.

Added together, these factors make it hard to see how the economy can maintain its recent rate of growth. More likely is a substantial decline in the rate of growth of GDP to a rate near 1 percent for several quarters. The risk of an outright recession – a decline in GDP – has not been higher since 1990.

The extent of the coming decline is not yet clear, but it could be much larger than the relatively small fluctuations we have had in recent years. Because we have never before experienced the unusual configuration of forces confronting our economy at this time, history is a less reliable guide to our future than usual. On the basis of the expected weakness in exports, and the investment and consumption patterns noted above, history would suggest that a recession is imminent.

But offsetting these weaknesses are some unusual strengths. The rapid increase in the value of the dollar has led to price declines of imports and of U.S. products that are sold in global markets. These price declines have bolstered the real purchasing power of households by as much as if they had received a tax cut of $100 billion. Furthermore, huge increases in asset prices over the last few years have greatly strengthened household balance sheets. These two forces—declining product prices and increasing purchasing power from capital gains—have put households in an enviable position. As a result, the decline in household saving rates does not need to be reversed immediately as it would have to be if household finances were more precarious.

Of course, for these unusual forces to continue to support household spending, investors must continue to support the value of U.S. securities as well as the value of the dollar in the international market. Hence, the extent of the coming slowdown will depend on the confidence with which American households and firms adjust to the coming disappointments in earnings growth and employment, and it will depend on the extent to which international leaders are able to hold their own policies steady in the face of the worsening storm. If international leaders are not up to the job, and if American households and businesses hunker down too suddenly, a major recession is possible.

Unfortunately, the storm is still worsening in Asia, particularly in Japan, which is by far the most important of the Asian economies. The repercussions on the U.S. economy of the Japanese difficulties will be significant. Even smaller countries, such as Indonesia or Korea, have the potential to disrupt the U.S. economy if they withdraw from the Western free-trade system. It must be tempting at this time for foreign governments to withdraw from the international economy. In the 1930s, political reactions to the depression were extreme, and the depression is widely portrayed as the cause of World War II. Even lesser responses could threaten our prosperity. A wave of expropriations, for example, could deal a major blow to American balance sheets. Huge political changes of this kind are hard for economists to conjure.

The Effects of Asia on the United States

To date, the Asian recession has not led to the default of a major American financial institution. Instead, the Asian difficulties have been transmitted to the United States through its effect on international currency flows, on the U.S. trade deficit, and through a widespread deflation in the prices of traded goods. While these factors added strength to the U.S. economy in early 1998, they will be a source of weakness over the coming year.

International Currency Flows

Over the last twelve months, the U.S. had a huge inflow of international currency seeking a safe haven. Originally, much of the inflow was directed at the equity markets and, as a result, stock values soared. More recently, bonds seem to have been the target.

As foreign investors sold their own stocks and bought American stocks, they caused these markets to move in opposite directions. In a self-fulfilling way, the increase in U.S. stock prices convinced these foreign investors that they had bought into strength, not that they were the source of the strength.

In April alone, Japanese investors sent $25 billion abroad, much of it to the United States. The currency flow associated with this move raised the value of the dollar and reduced the value of the yen (See Figure 5). As a consequence, the dollar has now risen to a level that makes no sense on the fundamental economic grounds of relative production costs or relative purchasing power. This phenomenon, Purchasing Power Parity, is the norm to which currency values seem to move over the long run, and the dollar is now way above its intrinsic value as measured by the purchasing power norm.

A Growing Trade Deficit

The huge and growing inflow of funds must be accompanied—by the iron laws of double entry bookkeeping—by a huge and growing deficit on goods and services trade. In economic terms, the demand for dollars from abroad to pay for U.S. goods AND to pay for U.S. investments must equal the supply of dollars by Americans wishing to purchase foreign goods and investments. Hence an inflow on the investment side must be matched by an outflow on the goods and services side. If these two do not balance, currency values will move until the excess supply or demand for dollars is removed and a new equilibrium is attained.

Because of the increase in the value of the dollar, the U.S. current account deficit, which had averaged $155 billion in 1997, rose to $225 billion in the second quarter of 1998, the last quarter for which data are available at this writing. This is a move of almost one percent of GDP.

This growing U.S. trade deficit reflects a decline in demand for U.S. manufactured products. Because the dollar has climbed so high, exports of manufactured goods are falling and are expected to continue to fall through much of 1999.

Had the huge Asian recession not led to an inflow of Asian capital into America, the declining demand for American exports would have led to a decline in the value of the dollar, not to an increase. While the market for U.S. exports would have been weakened substantially by the recession abroad, American exports would have remained competitive in price if the value of the dollar had fallen. But the collapse in asset values abroad and the extremely strong performance of the U.S. economy led to capital inflows, and it is these inflows that have caused the dollar to rise in value, greatly worsening the ability of U.S. firms to export.

Somewhat surprisingly, imports have not surged at a rate consistent with the decline in exports. Among the reasons for this are the following:

• Financial difficulties abroad have made it hard for foreign exporters to obtain the capital necessary to support their sales.
• An unusual clogging of port facilities has taken place in which empty containers are piling up in the United States because they have nothing to carry back across the Pacific in a westerly direction. Hence importers are now being forced to pay for transport of these containers both ways including the empty trip to Asia. Unsnarling these tie-ups will take time.

• The J curve is a relationship that suggests that countries can benefit temporarily from a revaluation as their imports become cheaper. That is, a 20 percent decline in import prices can cause an increase in import volume of something less than 20 percent in the short run. Hence the dollar value of imports can fall in the short run despite the increase in the value of the U.S. dollar. This effect can sustain itself even in the long run in markets for necessities, like petroleum, where the response in volume is typically less than the change in price. But for manufactured goods, the increase in volume almost always turns out to have been greater than the decline in import prices, and for this reason, currency appreciations tend to lead to increases in expenditures for imports. We have yet to see the surge in imports of manufactured goods that one would expect on the basis of the large increase we have seen in the value of the dollar.

All of these factors suggest that a substantial increase in imports is likely to occur in 1999.

Price Deflation

The increase in the value of the dollar brought with it a welcome decline in the cost of raw materials and commodities that eliminated the risk of price inflation in the United States in 1998, despite a substantial acceleration in wage inflation (See Figures 6 and Figure 7).

The good news is that because these prices have been declining, the Federal Reserve did not see fit to raise interest rates despite a pronounced acceleration of wages. As a result, the U.S. economy has been permitted to grow to levels of labor utilization not seen since the 1960s, which has been wonderful for those workers who are hard to employ. The reduction in short-term rates by the Fed on September 28, 1998, may be the first decline of many.

The bad news about declining prices is that lower prices make it harder to earn profits. Declining profits are becoming a problem, especially in basic industries, though I expect this problem to appear in more industries soon. As earnings forecasts have been trimmed, the stock market has taken a beating.

Viewed as deflation, the phenomenon of price decline has scared some observers. But deflation in materials prices has not been matched—nor is it expected to be matched in 1999—by a deflation in wages, or in products made resulting from wages. Furthermore, the decline in materials prices looks much worse measured in dollars than in other currencies. Because the dollar has risen, materials prices have fallen much less measured in terms of non-dollar currencies. For example, the combination of an increase of 30 percent in the value of the dollar and a decline of 20 percent in the prices of some traded commodities would suggest that these commodities have increased by 10 percent in terms of non-dollar currencies.

We should also remember that many raw materials markets have always been characterized by flexible prices, and specifically, by prices that tend to decline in recessions. This has not been the case for the prices of manufactured goods (or indeed of anything produced from labor). The worldwide recession has led to a reduced demand for raw materials. The very large increase in the value of the dollar has accentuated the decline in commodity prices to American buyers. But the character of the decline is not different from that in past worldwide recessions.

Just for the debate, we should note that there is a serious and dangerous form of deflation, but we are unlikely to encounter it in the foreseeable future. The dangerous form of price deflation would be deflation of all wages and prices at rates significantly below zero. This would be accompanied by two kinds of problems: First, wage deflation has always been extremely awkward to live with. It has been strongly resisted by workers and seems historically not to have taken place unless accompanied by very high levels of unemployment that act as a threat to worker security. But no one anticipates wage deflation in 1999.

Second, while prices can easily adjust to negative rates of change, interest rates cannot. If prices of houses are expected to fall by 10 percent per year, for example, people might still buy houses if they could get a mortgage at -5 percent. But since mortgage rates must be positive, the real interest rate charged to home buyers would go up with deflation and this would cripple the demand for new houses. A similar logic can be applied to all acts of investment, which would fall to very low levels during a serious deflation.

Instead of this dangerous form of deflation, we have enjoyed the more benign form of deflation, which is simply a decline in the value of imported prices and traded commodities. And just as declining oil prices gave the American economy a shot in the arm in 1986, declining materials prices have boosted real purchasing power in 1998.

The Effects of Consumer Confidence

Optimism has been a source of strength for the U.S. economy throughout the current expansion. It has helped keep stock prices high even in the absence of foreign funds. Over the last year, optimism has fed the demand for residential construction.. Consumer durable purchases have also remained strong in recent years.

But consumer confidence has declined substantially in the last few months, though it remains at a level that has been consistent with strong spending in the past. However, if consumers pull in their horns in 1999, or if banks tighten up on consumer credit, a decline in GDP would then be likely.

In the second quarter of 1998, the last quarter for which data are available, household income growth slowed substantially, yet consumption continued to grow as if there had been no decline in income growth. This unusual performance was made possible only by an alarming decline in the household saving rate to a level of 0.6 percent. Perhaps this decline in saving was so large we should dismiss it as an anomaly or possibly even as an error in the data. But taking it at face value, this unprecedented decline can not be expected to continue. Had there not been such a large decline in saving rates in the second quarter, GDP growth would have been negative.

The most likely explanation of the decline in saving rates is that the strong performance of the stock market has given consumers the confidence to spend some of their accumulated stock market profits. This raises the question of what will happen when stock market profits are harder to come by. In particular, how will consumers respond to the decline in the stock market we have already seen in August and September of 1998? Or how would they respond to an even larger decline if one were to occur in October? Of course, there are so many accumulated gains from the strong stock market of the past several years that consumers will not be unduly pinched by the decline in equity prices that occurred in the summer of 1998, though that decline may lead to a return of saving rates to normal levels. A sudden move toward higher saving rates on the part of consumers right when other sectors are weak would lead to recession.

The Transition from Strength to Weakness

Until August 1998, the U.S. economy was characterized by the following strengths:

• A strong stock market supported consumer purchasing power, even as income growth slowed.
• Foreign funds poured in to take advantage of the strong stock market. These inflows ended up supporting the American market even as American households ceased to save.
• The influx of foreign funds caused value of the dollar to increase, which led to lower product prices, a decline that further supported household spending.
• Spending was so strong that the economy grew substantially, and unemployment continued to fall.
• Wage increases accompanied the low unemployment rates—as usual—but because of the declining import prices, the higher wages did not lead to higher product prices, and the Federal Reserve did not have to increase interest rates to abort the expansion.

In summary, the large inflows of capital in early 1998 helped the economy to expand in the short run, but sowed the seeds of decline for 1999. The stronger dollar led to a substantial worsening in the trade balance, which is likely to continue, and which will lead to a decline in manufacturing activity in coming quarters. Furthermore, the decline in product prices and in the value of the dollar has hurt profits. This is a major reason for the decline in stock prices from their highs of early 1998. These declines are likely to hurt capital investment in coming quarters.

In August and September, things clearly began to change. Accompanying the decline in stock prices was a sharp decline in long-term interest rates, which is often a harbinger of recession (See Figure 8). Furthermore, the dollar fell quite sharply against both the yen and the deutsche mark. If these related declines are a signal that the inflow of funds from abroad has slowed, several of the forces outlined above will reverse themselves. The end of increases in the value of the dollar, for example, would bring an end to the decline in commodity prices, which would not only end the consumer‘s feeling of well-being, but which could lead many in the Federal Reserve to want to increase interest rates, not reduce them.

If the dollar continues to fall, it will cease to be a source of short-run support to the economy. While it will also cease to be a long-run drag, the long-run effects take so long that we might encounter a whipsaw in coming quarters of reductions in short-term strength from coming declines in the dollar combined with reductions in long-term strength from past increases in the value of the dollar. This combination would bring recession.

The Yield Curve

The most accurate indicator of recession in recent years has been the yield curve (See Figure 9). Rick Mishkin of the New York Federal Reserve Bank was the first to note that whenever the yield on 90-day Treasury bills falls below the yield on 10-year Treasury bonds, a recession has followed. In September the yield on 10-year Treasurys fell below the yield on 90-day Treasurys. This has happened eight times since 1954, and all but one time a recession has followed. The one exception was in 1966 when the private economy entered a recession, but the decline in private spending was offset by a large increase in military spending.

An obvious criticism of this methodology is that the result could happen by chance. One out of every 256 indicators would get eight out of eight predictions right even if the predictions of all indicators were simply based on coin flips.

But there is a theory of the yield curve that suggests that its behavior is not random. An investor seeking a 10-year investment would be willing to hold a 10-year security even if its rate was below the rate available on shorter securities if the investor thought the short-term rate was about to decline. This is true because if the short-term rate was about to decline, the investor would be worse off holding a sequence of short-term securities than by holding the 10-year bond available today. The investor might start out ahead by buying the higher yielding shorter term security, but when the security came due, he or she would be unable to re-invest the funds at the same high rate.

Thus the theory suggests that an inverted yield curve is evidence that investors expect short-term interest rates to decline, and an expectation of declining short-term interest rates is an indicator of recession. The chart shows that earlier this month, the yield on the 90-day Treasury bills briefly poked above the yield on the 10-year Treasury.

The Effect of Asia on Wisconsin

The Wisconsin economy is to a great extent dependent on the worldwide market for capital goods. I expect capital goods demand to weaken substantially in 1999. Indeed, I expect capital goods to be one of the weaker sectors in the whole economy in 1999 (See Figure 10).

The construction industry was the first to feel the effect of the Asian collapse. The production of construction equipment abroad has already fallen substantially, as have exports. Domestic manufacturers of construction equipment have no need to expand capacity at this time, so their own demand for capital goods will be minimal.

The demand for capital goods in basic industries has also declined substantially. For example, agricultural equipment manufacturers expect a sharp decline in sales in 1999 as lower worldwide grain prices have led to lower demands for machinery by American farmers.

American steel manufacturers are having great difficulty competing with foreign producers at today’s exchange rates. While this industry was at full capacity a year ago, there is no hint of a need to expand capacity today. Instead, this will be one of the first industries to ask the U.S. government for protection from imports. It will be interesting to see how the demand for protection plays out. Law provides protection to American manufacturers from Adumping. Dumping is defined as selling products in the American market at prices below those charged at home. But as a result of the recent currency devaluations, foreign manufacturers can lower the prices they charge in America without having those prices fall below the prices they charge at home. More and more industries will find themselves in the position of these basic industries as 1999 progresses.

This analysis suggests that the full effect of the Asian difficulties on domestic investment in the United States will be far greater than would have been predicted on the basis of lost export markets alone. The problem is that worldwide capacity in many industries now exceeds demand and that the prices of these industries – products have fallen so far that it is not profitable to expand production anywhere on the globe. As these industries confront the problems of excess capacity, they will reduce their own demand for capital goods and sales of capital goods by U.S. manufacturers to U.S. manufacturers will fall.

In addition to the fact that a decline in any industry leads it to purchase fewer capital goods, capital goods manufacturers also will be especially vulnerable to a decline in export sales in their own industries. There are several reasons for this:

• We export far more capital goods than consumer goods despite the fact that domestic consumer sales are so much larger than domestic capital goods sales. Put differently, export sales are a far larger percentage of total sales for capital goods producers than for consumer goods producers.
• Capital goods producers tend to pass changes in exchange rates into their product prices much faster than do consumer goods industries. Thus export sales will fall faster in capital goods industries than in consumer goods industries. Possibly, this is because capital goods producers tend to be smaller in size than consumer goods producers and are less able to ride out a period of loss that would take place if they were to absorb the adverse move in the value of the currency rather than to pass it through into product prices.

For these reasons, I expect hard times for capital goods producers in 1999.

Summary

Real growth in the next four quarters is likely to be below 2 percent for the United States. A few quarters are likely to have growth below 1 percent.

There is a risk of a major recession in 1999. This risk is larger than at any time since 1990. This recession is more difficult to call than some past ones have been because the U.S. economy is fundamentally sound at this time and because the outlook for the long term is brighter than it has been in a long time.

Because capital goods manufacturing represents a disproportionate share of Wisconsin's economy, and because capital goods manufacturers will bear a disproportionate share of the response to the Asian difficulties, it is likely that Wisconsin will feel the effects of the Asian recession to a greater extent than the average state will. Thus unlike the 1990 recession, when capital goods performed better than the average industry and Wisconsin performed better than the average state, if we were to encounter a recession as a result of the Asian difficulties, Wisconsin's performance would probably be below average.