Economic Outlook for 2000

Professor Donald A. Nichols
Department of Economics
University of Wisconsin–Madison

September 1999

A Return to Normalcy in 2000

The economy is following the trends identified in my last forecast, which was released in March 1999.

The trade deficit has continued to worsen, inflation has gone up marginally, and the negative household saving rate has fallen even further. Manufacturing has been hurt by the collapsing trade deficit, and Wisconsin’s dependence on manufacturing, combined with its shortage of available labor has caused it to grow more slowly than the nation as a whole. While this configuration of forces is not sustainable on an indefinite basis, there is no reason that it needs to end in the year 2000.

The negative saving rate of American households suggests that they are no longer contributing strength to the stock market. Indeed, it is likely that it is the stock market that is supporting household spending. High stock prices, in turn, have been supported, at least in part, by the huge inflow of funds from abroad, which are financing the American trade deficit.

Following the Asian crisis of 1997, the world’s economy entered an unusual phase in which the United States grew strongly while most other regions stagnated. As a result, U.S. exports fell sharply in 1998, and its imports rose sharply in early 1999. Meanwhile foreign investors placed huge volumes of funds into American securities because the risks of investing elsewhere increased markedly. This drove the dollar up, making life even more difficult for American producers.

At some date, we will see the unwinding of these forces. Recovery abroad will begin and foreign funds will start to flow out causing U.S. stock prices either to fall or to be supported by an unlikely increase in American saving. In either of these cases, the long-awaited slowdown in the American economy will finally take place. The question is whether a major unwinding of this kind will take place in the year 2000 or at some later time. At this date, the best bet is for a slow unwinding to begin soon, but not to get out of hand in early 2000.

The risk of financial collapse is much lower today than it was a year ago. Banking difficulties are in the process of being worked out in many countries, especially in Japan. While Japan’s macroeconomic equilibrium remains precarious, most observers feel it is poised for growth. In support of this likelihood, dollars have been pouring into Japan seeking investment opportunities, and the yen has strengthened considerably.

The year 2000 will differ from 1999 in that foreign economies will grow more strongly, the probability of inflation in the U.S. will increase, and interest rates are likely to be higher. The Y2Kproblem is unlikely to cause any major glitches to the economy’s performance. About Y2K, Alan Greenspan has said that we have nothing to fear but fear itself. Most forecasters have come to agree that the most likely effect of the Y2K problem, barring a public panic, is a modest increase in inventory accumulation in the next few months, with sales of Y2K-related products peaking in late December, followed by a slow first quarter as these inventories work through the household pipeline. The likelihood of panic is unknown, though some have suggested that a panic is more likely if there is no other thrilling news to grip the public’s attention in the last two weeks of 1999. Any cub reporter told on December 26 to go out and find a few stores that have already run out of flashlight batteries is going to be successful, just as would be the case in any other week. But in late 1999, even a normal level of spot shortages can be turned into big news.

The world’s major economies have turned a corner and are unlikely to decline in the near future. Whether Europe or Japan grows strongly in 2000 is not as important to the outlook as the fact that they have stopped declining and that forces of growth are appearing. Their growth will begin a long process of recovery in the U.S. trade deficit, probably back to the levels seen just before the Asian financial collapse of August 97. Certainly the current high level of the U.S. trade deficit cannot be sustained indefinitely. As the forecast of growth abroad becomes increasingly secure, foreign currencies will strengthen, and the weaker dollar will make American exports more competitive in world markets.

The U.S. trade deficit, which has been running at annual rates of over $300 billion in recent months, should begin a turnaround in 2000. This is because the anticipated recovery abroad will bring with it an increased demand for American products. The weaker dollar will end the displacement of American products by cheaper foreign goods both in foreign and domestic markets. This means that manufacturing activity in the U.S. will end its recent decline and begin to recover from the unusual challenge it has faced in the last few years.

In recent years, exchange rates have fluctuated much more widely in response to short-term financial flows than to trade flows. Financial flows are much more difficult to predict than trade flows because they depend on investor psychology. Most recently an anticipated recovery of the Japanese economy has led to a huge flow of currency into Japanese investments causing the value of the yen to increase (see figure 1). The Bank of Japan has intervened to restrain the increase in the value of the yen, but the yen is likely to remain strong for the foreseeable future. Other currency flows can crop up quickly in response to relatively small shocks. But the major forces underway indicate a likely recovery of the yen and the euro to levels that prevailed a few years ago. This is because the recovery in those economies is expected to reduce financial risk and to lead to increases in interest rates that make their asset markets more attractive than they have been recently.

The smaller Asian economies have already begun to recover. Korea in particular is doing well. The Asian Development Bank forecasts that Korea will grow by 8 percent in the coming year. The risk of collapse in these economies has fallen substantially, and this lessens the likelihood of worldwide financial panic. On the other hand, there has been no major change in international monetary institutions to curb the kind of financial flows that led to the Asian collapse two years ago. Because of this we may continue to witness some very large movements of exchange rates in response to seemingly small changes in underlying economic fundamentals.

It remains to be seen how American investors will respond to higher interest rates at home. The Federal Reserve will not be constrained from raising interest rates over the next year, as they were in 1998 and early 1999, when they feared that higher interest rates could exacerbate the strains caused by an overvalued dollar. Any hint of domestic inflation – or even of strength in the sectors that have led to inflation in the past – could lead to higher interest rates in the future, because higher rates could also help stabilize the dollar against further declines in value. That is, from now through the year 2000, higher interest rates could help solve both foreign and domestic problems at the same time, whereas in 1998 or early 1999, higher interest rates might have helped solve the domestic problem of an overheated economy but would have worsened the international problem of an overvalued dollar.

At this writing the Bank of Japan is asking the United States to intervene to help stop the strong recent appreciation of the yen. One standard way to stop such an appreciation would be to raise U.S. interest rates.

An increase in interest rates will threaten the stock market. Because of the economy’s increased dependence on the stock market to sustain consumer spending, any decline in stocks is likely to be accompanied by a decline in spending. Consumers are financing their spending with capital gains on stocks and with increased borrowing against the equity values of residences. This does not necessarily mean that second mortgages or mortgage refinancings are supporting household spending. The normal turnover of ownership of residences can be associated with increased mortgage holdings if the buyers take on mortgages that are larger than those being paid off by the sellers. When interest rates decline, a surge in mortgage borrowing has been associated with a surge in consumer spending in recent years.

The stock market has received important support from foreign investors in the last few years as the United States often seemed to be the only safe haven for investments. This source of support may be waning as investors regain confidence in markets abroad. U.S. stock prices may be vulnerable to a lack of support from abroad, in which case a decline in both the market and in consumer spending could cause a slowdown. The most recent survey of forecasters by the Philadelphia Federal Reserve Bank does not show much support for this possibility, however.

On the domestic front, inflation is more likely to rise in 2000 than it was in 1999. This too will increase the likelihood of the Fed raising rates. The increased risk of inflation is a result of a further tightening of labor markets, which will lead eventually to higher wages and to an increase in the prices of raw materials that will result from the weaker dollar and from the recovery abroad. Many raw materials prices are set in world markets. These prices have been very low in recent years because foreign demand has been weak. As foreign demand strengthens, materials prices will begin to increase.

Even the increase in the price of oil is due in part to the economic recovery and to the prospects of a further recovery. Except for a few brief periods, OPEC has found it difficult to allocate production quotas among its members in a way that encouraged sufficient cooperation for the cartel to raise prices. Whenever the cartel was successful in the past it was during a time of worldwide boom. It is easier to maintain a cartel in the face of rising demand than when sales are falling.

Every indication from the Federal Reserve is that they now view oil and food prices as being determined primarily by forces other than the level of economic activity. Hence the recent increase in oil prices by themselves is not a reason to expect interest rates to rise. But in the past, patience has quickly run out when the list of exceptions grew long. If we say there is no inflation except that caused by oil and food prices, and then we add inflation caused by worldwide increases in materials prices, and finally we add the increasing prices of imports, the overall inflation rate could move to such a great extent from these special factors that the Fed would act despite a lack of inflation in domestic wage rates and despite an improvement in the economy’s overall rate of productivity growth.

In the past, I have refused to give an inch to those who claimed that the inflationary tendencies of the U.S. economy had been lessened by its structural changes. All past relationships between inflation and economic activity seemed to me, if properly specified, to be just as strong in the 1990s as they had been in previous years.

Wage inflation in 1999, however, has been lower than these past relationships would predict. Figure 2 shows how wage inflation is less than would be predicted from the historical relationship between wages and unemployment. Only the future will tell if the lower level of wage inflation is a temporary aberration or if it is caused by some permanent change in the economy’s structure. If it is found to be a result of a change in the economy’s structure, it will be interesting to see if the change in structure is one involving a heightened level of productivity growth or simply an increase in competition from abroad.

It is interesting to note that the Index of Help Wanted Advertising indicates that the labor market is not as tight today as it has been at previous peaks in the business cycle (see figure 3). This index measures the tightness of the labor market from the perspective of job vacancies, and it suggests that the shortages faced by employers today are not as severe as at previous business cycle peaks when wage inflation has started to increase. The divergence of this indicator from its historical relation to the unemployment rate could have a variety of causes, among which could be that the growth of temporary help agencies. They have increased the efficiency with which unemployed workers are matched to job vacancies. It could also be because modern white collar workers are far more efficient at their own job searches than was the blue collar labor force of the past.

The Wisconsin employment data are difficult to interpret at this date. Overall, employment growth in Wisconsin appears to have fallen well below employment growth in the nation as a whole. Employment growth over the most recent twelve-month period has been about 1 percent in Wisconsin while it has been about 2.3 percent in the nation as a whole.

Usually a shortfall of this magnitude would take place only if the Wisconsin economy suffered from some weakness that was not shared by the rest of the country. Because I have come to trust the employment data to provide the most accurate indication of Wisconsin’s relative economic performance, I find the shortfall disturbing. However, I have been unable to find any confirming evidence of weakness in other Wisconsin data, such as car sales or sales of new houses. Hence at this date, I attribute the weakness in Wisconsin’s employment growth to a list of special factors rather than to a weakening local economy.

Part of Wisconsin’s shortfall is due to its disproportionate dependence on manufacturing, a sector that has suffered at the national level (see figure 4). There is no evidence that Wisconsin’s manufacturing sector has been hit harder than manufacturing elsewhere, but when manufacturing weakens at the national level, the national weakness hits Wisconsin harder than it hits most states.

Another part of Wisconsin’s shortfall is due to a shortage of workers, a force I have been noting for five years. Wisconsin’s unemployment rate remains at this date a full percentage point below the national rate (see figure 5). If employment grows strongly at the national level, it is just impossible for Wisconsin to keep up. An unemployment rate of 3 percent cannot fall much further.

Another factor could be that Wisconsin’s welfare reform programs were putting people to work well before the national programs were geared up. It is possible that the some of the recent growth in employment in the rest of the nation reflects a force that caused Wisconsin’s employment to grow strongly over a year ago.

Readers should also be cautioned that the local employment numbers have been subject to substantial revisions in the past and that next year, I might present a chart of Wisconsin’s employment growth that looks quite different from the chart in this report that provides evidence of the shortfall.

The employment shortfall appears to be especially acute in two sectors—temporary help and eating and drinking places. Both of these sectors hire a disproportionate share of low wage workers. If the labor force is incapable of further growth, these would be among the first sectors to experience a shortage of workers.

At the national level I anticipate growth to continue at a rate of 2.5 to 3 percent, and I expect Wisconsin’s growth to be about one-half to three-quarters of a percent slower than that. This forecast assumes a continuation of recent economic trends, including the large trade deficit and the negative saving rate, with some moderation in residential construction.

I expect the overall inflation rate to pick up by a full percentage point in the coming year, with some of the increase due to an increase in wage inflation and some due to an increase in raw materials prices.

The higher inflation is likely to lead to higher interest rates, partly due to market forces and partly due to actions of the Federal Reserve.

Figure One

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Figure Two

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Figure Three

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Figure Four

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Figure Five

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