A report on the June 14, 1991 meeting of the Fourth District Economists' Roundtable, at which the consensus forecast was for a mild gain in output growth in the early stages of economic expansion and for a subdued recovery in the consumer spending, housing, and capital goods sectors.Economic conditions - United States ; Business forecasting

John J. Erceg

Lydia K. Leovic

English

Research Papers in Economics

eCONOMIC
GOMMeNTORY
Federal Reserve Bank of Cleveland
An Anemic Recovery?
by John J. Erceg and Lydia K. Leovic
August 1, 1991
A he latest economic indicators are sig-
naling an end to the recession that began
last July. According to most forecasters,
a recovery has already begun, or is about
to begin shortly. Less certain are ques-
tions about the strength of the recovery
and about Federal Reserve policy in the
early stages of the upturn.
These issues were central to the mid-
year meeting of the Fourth District
Economists' Roundtable, held June 14
at the Federal Reserve Bank of Cleve-
land. The most current data available to
the panel suggest that the 1990-91
recession, the ninth economic contrac-
tion of the post-World War II era, ap-
parently ended in the spring months of
1991. If so, it would rank about average
in duration compared with the previous
eight recessions, which lasted an aver-
age of 11 months.
The 1990-91 downturn also represents
one of the mildest of the postwar reces-
sions in terms of GNP contraction, ac-
cording to the Roundtable forecasters.
The median of 24 forecasts shows a vir-
tual standstill in real GNP in 1991 :IIQ,
following a 1 percent decline between
1990:IIIQ and 1991 :IQ. This compares
with an average real GNP contraction
of 2.6 percent between peak and trough
quarters of the previous eight recessions.
Why do most forecasters believe that the
economy may be in or close to a recov-
ery? A number of leading indicators that
usually foreshadow economic recov-
eries by two to eight months advanced
between February and April, suggesting
to a Roundtable panelist that a business
trough occurred between May and July.
His computed estimate of the probability
of recovery grew to 98 percent in April.
Moreover, the Commerce Department's
composite index of leading economic in-
dicators rose for four successive months
between February and May. In the past,
consecutive increases of that length
have indicated that a trough occurred
within the last two months or will be
reached within the next six months,
according to a study by the Federal
Reserve Bank of Cleveland.
Although forecasters uniformly agree
that recovery in real GNP will get under
way by 1991 :IIIQ, there is disagreement
about its strength, at least in the early
months. In the first year of the seven re-
coveries since the mid-1950s, real GNP
rose 5.7 percent (6.7 percent if the
1949-50 recovery is included). The
median forecast of the Roundtable group
anticipates only about a 2.8 percent in-
crease in real GNP in the four quarters
between 1991 :IIQ and 1992:IIQ(see
figure 1).
• Two Recovery Scenarios
Estimating the strength of the early stage
of expansions has often eluded forecast-
ers, and divergent views about the out-
look are not uncommon. The current epi-
sode is a good case in point. At least two
scenarios of the economic outlook were
presented at the Roundtable meeting, one
calling for a relatively mild recovery and
another indicating a somewhat stronger
growth path for output. Both of these,
however, fall short of the real GNP
growth rate in the past recoveries.
Now that the economy appears to
have climbed out of recession, what
are the prospects for the early stages
of expansion? Forecasters attending
the most recent Fourth District
Economists' Roundtable expressed
divergent views about the strength of
the recovery, but their consensus is
for a subdued gain in real GNP
through mid-1992. A critical factor
will be the Federal Reserve's commit-
ment to controlling inflation as the
recovery unfolds.
The milder scenario is based on several
possible constraints that are likely to
inhibit the growth rate of the economy,
according to one of the Roundtable mem-
bers. These include a high level of private
debt, tax increases that have taken place
since last fall, relatively high interest
rates going into recovery, a long-term
downward adjustment in service-sector
employment, and waning consumer con-
fidence, all of which are likely to restrain
real GNP growth to a 2.5 to 3 percent
range at least through the end of 1992.
An alternative view is that the upturn
will not be as weak as indicated by the
median forecast. The brighter scenario
expects that real GNP will grow at close
to 4 percent in the first year of recovery.
The business upswing will be supported
by lower oil prices since late 1990,
which have cut production costs and in-
flation; lower interest rates over the past
year, which should encourage interest-
rate-sensitive investment; a lower dollar
ISSN 0428-1276in exchange markets between mid-1989
and early 1991, which has encouraged
net export growth; and a turnaround in
corporate profits and cash flow, which
will support increases in capital spend-
ing. Consequently, a comeback in the
cyclically sensitive sectors, including
consumer durable goods, inventories,
business fixed investment, and residen-
tial construction, should boost total out-
put at a faster rate than is expected in
the slower recovery outlook.
• Constraints to Recovery
At the initial stage of economic recov-
eries, the largest thrust typically comes
from consumer spending for durable
goods, residential construction, and
business investment. Most Roundtable
economists, however, expect a lack-
luster recovery in each of these tradi-
tionally leading economic sectors.
Consumption: Following a severe con-
traction in consumer spending between
1990:HIQ and 1991 :IQ, a recovery is ap-
parently under way, but it should proceed
at a relatively subdued pace, according to
two economists associated with consumer
goods markets (see figure 2). The 1990-
91 slump in consumer spending was one
of the worst in recent recessions. Year-
over-year growth in personal income fell
from about 6 percent in mid-1990 to 3
percent by the spring of 1991, and real in-
come performed weakly.
The panelists expect a less-than-typical
rebound in consumer spending, at least
during the early stages of recovery, be-
cause of slow expansion in consumer
credit and in real disposable personal
income. A demographic shift toward
consumers who tend to spend less of
their disposable incomes will be a drag
on consumer spending over the next
few years, according to one economist.
The main stimulus to a revival in this
sector is lower prices for consumer
goods. For example, price increases for
retail apparel should remain below 2
percent because of high inventories and
a strong dollar overseas. In addition,
the recession has forced down housing
prices. As demand for housing in-
creases, the sale of consumer durable
goods, such as home appliances and
furnishings, should step up.
The slump in auto sales and production
during the 1990-91 recession was
worse than typical, but the auto indus-
try has been gradually recovering. New
car and truck sales rose substantially in
May and June from levels of previous
months, and the industry is hopeful that
these rates can be sustained. The con-
sensus forecast for domestic auto and
light-truck sales for 1991 is 12.8 mil-
lion units; in 1992, sales are predicted
to be about 14 million units. It was also
noted that fleet sales have given a sub-
stantial boost to auto production sched-
ules, but the growing popularity of
these "nearly new" cars has had a
dampening effect on new car sales.
Housing: Residential construction is
expected to rebound in the first year of
the 1991-92 recovery with only half
the vitality of past upturns. Following
each of the past seven recessions, resi-
dential construction increased in a
range of 22 to 35 percent, except for
the 1961-62 and 1980-81 expansions,
which saw either a smaller revival or
an outright decline. A housing econo-
mist pointed out several reasons for ex-
pecting a slower-than-typical rebound
in housing.
The expected mild economic recovery,
accompanied by slow income and
wealth growth, of course, is one factor.
The declining trend in the prime home-
buying age bracket (ages 25 to 34) and
the reduced pace of new household for-
mations to a rate of about 1.3 million
per year will also slow demand for
housing. This economist also stated that
the user cost of capital in housing has
risen since the Tax Reform Act of 1986
was enacted. Moreover, the real inter-
est rate for mortgages (the fixed mort-
gage rate less expected home price
appreciation) has been climbing toward
7.5 percent, the highest rate since the
mid-1980s, because of a decline in
home price appreciation in recent years.
Finally, there is an abundant supply of
unsold single- and multiple-family
units. In view of these conditions, total
new housing starts are expected to rise
FIGURE 1 REALGNP
Percent change
-1 -
1991 1992 IIQ IIIQIVQ IQ IIQ IIIQ IVQ
1991 1992
FIGURE 2 REAL PERSONAL
CONSUMPTION EXPENDITURES
Percent change
1991 1992 IIQ IIIQIVQ IQ IIQ IIIQIVQ
1991 1992
NOTE: All bars represent median forecasts. "High" and "low" are an
average of the three highest and lowest forecasts, respectively.
SOURCE: Fourth District Economists' Roundtable, June 14, 1991.
to about a 1.3 million to 1.4 million level
over the next several quarters (see figure
3) and to remain there for much of the
1990s.
Capital Goods: The consensus view
from capital goods producers is that the
recovery in this sector will be slow,
reflecting the high cost of capital com-
pared with its levels in past economic
upturns. Reduced tax incentives and
steeper real rates of interest have con-
tributed to a higher user cost, according
to one economist.
The information processing industry,
which accounts for nearly half of pro-
ducers' durable equipment, has not been
insensitive to the 1990-91 recession.
Historically, every recession in com-
puter machinery has preceded a busi-
ness downturn by approximately threeFIGURE 3 HOUSING STARTS
Millions of units
1.5
1.4
1.3
1.2
1.1
1.0
0.9
_
in
High, r—l
—n
Low
1991 1992 IIQ IIIQIVQ IQ IIQ IIIQ !VQ
1991 1992
FIGURE 4 GNP IMPLICIT
PRICE DEFLATOR
Percent change
1991 1992 IIQ IIIQIVQ IQ IIQ IIIQIVQ
1991 1992
NOTE: All bars represent median forecasts. "High" and "low" are an
average of the three highest and lowest forecasts, respectively.
SOURCE: Fourth District Economists' Roundtable, June 14, 1991.
months. Although it was able to avoid
the national recession in 1980, the
industry experienced a contraction in
1984—86 and slipped into another reces-
sion before the officially announced
business downturn in July 1990. Do-
mestic demand for office equipment
has shown virtually no growth for the
last four to five years. However, some
favorable developments have surfaced
recently. New orders and shipments of
electronic components used in the of-
fice machinery and computer industry
have picked up, as has the ratio of new
orders to shipments, suggesting a near-
term revival in the computer industry.
• Credit Markets
Credit availability is perceived as a con-
straint to business recovery, according
to some forecasters. Before the reces-
sion began last summer, public officials
and some economists expressed con-
cern that tight credit market conditions
could lead to a recession. A Fourth Dis-
trict panelist argued, however, that a so-
called credit crunch did not cause the
recession, nor will bank credit availabil-
ity inhibit a recovery.
Bank lending (commercial and indus-
trial loans) has been declining since
mid-1990, but credit availability to busi-
ness firms from other sources, including
foreign banks, financial companies, and
commercial paper, has been rising.
Total credit, therefore, has continued to
expand through at least mid-1991.
Rather than reflecting a supply con-
straint, the reduction in bank loans indi-
cates a longer-term downtrend in banks'
market share of credit, reduced demand
for credit in line with a weakening econ-
omy, and deterioration in credit quality,
according to the panelist. He acknowl-
edged that there could be "micro credit
squeezes that are industry and region
specific," but not a general credit
crunch, which in the past was asso-
ciated with regulatory policies that re-
stricted the total supply of credit. Symp-
toms of a credit crunch include rising
real rates of interest, an inverted yield
curve, and declines in credit outstand-
ing, which are just the opposite of condi-
tions that have prevailed since 1989.
The same panelist asserted that a credit
squeeze developed, however, because
the Federal Reserve supplied virtually
no growth in reserves, helping to slow
economic growth since 1989 and in
turn curtailing bank loan growth. At the
same time, banks tightened credit stan-
dards for loans to some industries (such
as real estate) and to some regions of
the country (such as the East Coast).
Nevertheless, the tightening and re-
structuring in banking will not inhibit
the recovery, according to the panelist,
because alternative sources of credit
are available.
• Why So Little
Progress on Inflation?
The underlying rate of inflation in the
1990-91 recession did not appear to be
much improved from its prerecession
rate (see figure 4). Little progress seems
to have been made toward reducing
either inflation or expectations about
inflation, despite a sustained moderate
growth rate in money stock (M2),
which has averaged about 4.5 percent
annually for the last four years.
Several explanations were offered at the
Roundtable meeting for this apparent
lack of progress. The current price
stickiness is not unexpected, according
to one economist, because inflation
usually lags a recession.
The persistence of high inflation and
high yields on long-term bonds since
early 1990 cannot be explained solely
by money stock behavior, according to
another Roundtable member. Moderate
growth in M2 in recent years should
have resulted in a 2 to 3 percent infla-
tion rate, if prices responded only to
money. However, in his money/price
model, only about half of the variation
in inflation can be explained. While in-
flation is a monetary phenomenon in
the long run, he said, nonmonetary fac-
tors are important causes of short-term
variances in the inflation rate. In 1990-
91, those factors include an oil price
shock, the long-run slide in the dollar,
and a surge in unit labor costs. Another
influence on price developments is Fed-
eral Reserve credibility, which affects
expectations of wage and price setters
when there is a discrepancy between the
Fed's actual and anticipated actions.
This economist predicts lower inflation
if the uncertainty about inflation and the
Fed's response are lessened.
Another panelist maintained that some
improvement in the inflation outlook is
yet to come. He expects the GNP implicit
price deflator, the broadest price measure,
to rise at nearly a 3.5 percent annual rate
through the end this year, as shown in fig-
ure 4. This scenario assumes several con-
straints on inflation, including relatively
weak economic growth and excess capac-
ity, which should restrict wage and price
increases; a continuation of the recent
strengthening of the dollar in exchange
markets; and an ongoing expansion in
money stock in a 3 to 5 percent range.• The Importance of
Federal Reserve Credibility
Discussion of appropriate monetary
policy during recovery and of how the
Federal Reserve System should
respond to inflation raised concerns
about the Fed's credibility. Some of the
Roundtable members asserted that the
steep yield curve and weakness in long-
term bond prices can be tied to uncer-
tainties about the Fed's commitment to
reducing the inflation rate. Money stock
and inflation usually increase during
business recoveries, and bond market
participants generally expect that the
Fed will allow the same outcome in this
expansion. Long-term investors are re-
ported to be uneasy about the extent to
which inflation might accelerate once
the business recovery gets under way
and about the Federal Reserve's re-
sponse. The bond market may be more
responsive to the inflation rates of re-
cent years than to the steady and mod-
erate money-stock growth in recent
years. Long bond yields, therefore, will
not decline until the inflation rate
recedes. Market participants also seem
uncertain about whether inflation or
economic growth is the Fed's primary
objective.
The Roundtable group saw several ac-
tions as being necessary for improving
the Federal Reserve's credibility. An
initial test of the System's anti-inflation
resolve, according to one financial
economist, will likely come early in the
recovery, when it may be necessary for
the Fed to take tightening actions to
keep M2 growth in line with its recent
average annual increase of 4.5 percent.
Such a bold move would raise credibil-
ity and lead to a bond market rally.
Also, the panelist prescribed an M2 tar-
get range for 1992 of 2.5 to 5.5 percent,
which represents a full percentage-point
reduction from the upper end of the
1991 target range. This narrowing
would signal to financial markets that
the System is serious about controlling
money stock growth and inflation. If
achieved, this midpoint would be con-
sistent with the four-year trend rate of
M2 growth.
• Conclusion
The recession's end has shifted atten-
tion to economic recovery and inflation,
and to how the Federal Reserve will
reconcile those objectives. Most mem-
bers of the Fourth District Roundtable
expect that the upturn will be mild,
marked by a rise in real GNP at about
half the average rate of increase that oc-
curred in the last seven recoveries.
Still, the expected growth path is not as
weak as it appears, because it is close
to the economy's long-term trend rate
of output growth. Policymakers may
be tempted to take actions to encourage
a higher GNP growth rate, but several
economists at the Roundtable meeting
urged the Federal Reserve to avoid
repeating past behavior that generally
added to inflation.
The specific policy prescriptions of-
fered by some of the Roundtable mem-
bers are not necessarily shared by the
entire group. Their views highlight,
however, the importance of the Federal
Reserve System's credibility in altering
inflation expectations as an effective
anti-inflation policy strategy.
• Footnote
1. See Gerald H. Anderson and John J.
Erceg, "Forecasting Turning Points with
Leading Indicators," Federal Reserve Bank
of Cleveland, Economic Commentary, Oc-
tober 1, 1989.
John J. Erceg is an assistant vice president
and economist and Lydia K. Leovic is a
senior research assistant at the Federal Re-
serve Bank of Cleveland. The authors would
like to thank Gerald H. Anderson and
Michael F. Bryan for helpful comments.
The views stated herein are reported by the
authors and are not necessarily those of the
Federal Reseiye Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
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Material may be reprinted provided that
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An anemic recovery?

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An anemic recovery?

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