A summary of the January 18, 1991 Fourth District Economists' Roundtable, noting the panelists' forecasts for the economy in the wake of uncertainties surrounding the Persian Gulf War.Business forecasting

John J. Erceg

English

Research Papers in Economics

February 1, 1991
eCONOMIG
GOMMeNTORY
Federal Reserve Bank of Cleveland
1991 Outlook: Mild Recession,
Mild Recovery
by John J. Erceg
X he U.S. economy has been buffeted
in the past few months by uncertainties
surrounding the Persian Gulf War and its
effects on crude oil supplies and by a
strained financial sector domestically.
Though these factors can make short-
term economic forecasts highly unpre-
dictable, members of the Fourth District
Economists' Roundtable, who met
January 18 at the Federal Reserve Bank
of Cleveland, project that the current con-
traction will be brief and that economic
growth will resume by mid-year.
The Roundtable economists acknowl-
edge that a contraction in economic ac-
tivity began in the fourth quarter of
1990, but have different views on what
caused the decline. They concur, how-
ever, that a brief war in the Middle East
is not expected to either deepen or pro-
long the present economic downturn,
as long as crude oil supplies are not dis-
rupted. The economists also predict
that a mild recovery will ensue by the
second half of 1991, against a backdrop
of a gradual reduction in interest rates
and a lower inflation rate.
• The Oil Price Enigma
Some of the Roundtable economists as-
sert that the oil price shock last August
is the prime culprit in the current eco-
nomic decline, as it led to severe erosion
in consumer and business confidence
and spending. Another explanation is
that concern about the prospects of war
in the Middle East was a primary factor
that generated spending cutbacks, and
that consumer and business outlays will
revive as some of the uncertainties are
resolved. According to one economist,
the shock to consumer confidence was
similar to that of early 1980, when the
announcement of credit controls resulted
in a sudden and sharp cutback in spend-
ing and real GNP. Confidence was re-
stored when credit controls were lifted
in mid-1980, spending subsequently
rebounded, and the brief six-month
recession ended.
The Roundtable panel apparently
believes that a short war in the Persian
Gulf is unlikely to have much of a nega-
tive effect on the economy, assuming
that oil supplies, particularly from Saudi
Arabia, are not disrupted. In this event,
the price of crude oil would likely hover
around its long-run price of about $20
per barrel, according to one economist.
Supplies are judged to be plentiful be-
cause of higher output by Saudi Arabia
and other oil producers that more than
compensates for the embargo on oil
exports from Iraq and Kuwait.
If oil supplies do become disrupted,
however, the economists predict that
crude oil prices and inflation would
surge and that consumer spending and
eventually business investment would
decline, serving to deepen the contrac-
tion. It is the fear of future supply dis-
ruptions that accounts for last year's
wide swings in the spot and futures
prices. As that fear waned, crude oil
prices fell to a recent average of about
Forecasters who attended the Fourth
District Economists' Roundtable
meeting two days after the outbreak
of war in the Persian Gulf last month
were generally optimistic about the
potential economic effects of the con-
flict. The economists believe that as
long as oil supplies remain adequate,
a brief war should have minimal im-
pact on the current economic contrac-
tion, and predict that mild growth in
output should resume in the second
half of the year.
$20 per barrel, from an average high of
about $40 per barrel early last fall.
• Contraction and Recovery
Members of the Roundtable believe that
the worst of the contraction in real GNP
was in 1990:IVQ and that after a mild
decline in 1991 :IQ, growth of the econ-
omy will resume by mid-year. Real GNP
was estimated to have declined at a 2.6
percent annual rate last quarter, accord-
ing to the median of 27 forecasters at
the meeting (table 1).' Another decline
at a 1.5 percent annual rate is expected
for this quarter, and after a flat 1991 :IIQ,
real GNP growth is predicted to rebound
to a 2.7 percent annual rate in the sec-
ond half of the year and to nearly a 3
percent rate in the first half of 1992.
ISSN 0428-1276According to the median projection of
the group, the current contraction is ex-
pected to be one of the mildest and brief-
est in the postwar period. The average
decline in real GNP in the eight reces-
sions since 1948 was 2.5 percent, and
the average length of the downturns was
11 months. In contrast, Fourth District
forecasters expect that real GNP will
drop only about 1.1 percent between
1990:IIIQandl991:IIQ.
Similarly, the recovery anticipated by
the Roundtable group would also rank
as one of the mildest in postwar experi-
ence. In the first four quarters of the
average recovery since 1948, real GNP
rose 5.7 percent. For the four-quarter
economic upturn that is expected to
begin by mid-1991, the Roundtable
forecasters anticipate a 3.2 percent in-
crease in output.
One economist offered his explanations
for this atypically shallow contraction
and shallow recovery. To begin with,
economic growth had been slowing
gradually for two years before the pre-
sumed peak in 1990:IIIQ. Consequently,
business firms were able to adjust pro-
duction to a gradually slower product
demand and avoid an inventory overhang
that has typically steepened declines in
economic activity. Moreover, he pointed
out, a long-term shift in the mix of the
economy has been taking place, contrib-
uting to different patterns of economic
behavior by industry and by region.
Consumption, residential investment,
and government purchases have been de-
clining as shares of GNP, while exports
have been rising. Manufacturing indus-
tries are likely to outperform service-
producing industries because restructur-
ing in manufacturing in the 1980s led to
lower production costs, while service-
producing industries that usually do well
in recessions, such as financial services
and retail trade, will be underperformers,
resulting in potentially large layoffs.
Why is a milder-than-typical recovery
expected? Obviously, some of the down-
ward adjustments from the changing
mix of the economy are not yet com-
plete, so that real estate, financial serv-
ices, and retail trade will continue to
underperform the rest of the economy.
Problems in those industries are not ex-
pected to spread unless final demand in
the economy declines. Moreover, the
Roundtable panelists believe that the
Federal Reserve System is likely to con-
tinue a disinflationary policy, unlike its
posture during past recoveries that were
stimulated by rapid expansion of money
and credit.
Alternative scenarios for both the con-
traction and recovery stages were ap-
parent at the Roundtable meeting. A few
panelists expect that economic growth
will revive in 1991 :IQ, following only a
one-quarter decline. Another forecaster
expects a double-dip recession in 1990-
91 and in 1992. In his view, the present
contraction was triggered by the fear of
a Middle East war. Another dip in
economic activity could occur in early
1992 in response to the oil price shock
last summer, unless the price of crude
oil were to drop to a sustained level of
about $15 per barrel.
• Inflation
The trend rate of inflation in the post-
World War II period has averaged
about 4 percent annually, with consider-
able oscillation around that figure.
Most private and public forecasters
have projected a 4 percent inflation rate
well into the mid-1990s, apparently be-
cause of a perception that the Federal
Reserve and the public are willing to
accept that rate.
Inflation expectations now appear to be
slowly adjusting downward, at least for
the short term, despite the flare-up in
price pressures last year. The Roundtable
consensus is that the GNP implicit price
deflator, the broadest price measure,
reached a recent peak rate of 4.8 percent
last quarter and will recede to a 3.9 per-
cent annual rate this half. Between 1991:
IIIQ and 1992:IIQ, the forecasters antici-
pate an annual average rate of increase of
3.3 percent, about matching the 1985-87
average. This figure is slightly more opti-
mistic than the 4 percent rate the group
had forecast for 1991 last fall.
• Financial Market Conditions
Analysts have expressed considerable
concern about whether financial prob-
lems in the economy might worsen the
recession and constrain the recovery.
Some maintain that the availability of
funds from bank and nonbank sources
has already been curtailed more severe-
ly than during the troughs of some past
recessions. Discussants at the Round-
table, while acknowledging more
restrictive credit extension by banks, do
not believe that the economy is in a so-
called credit crunch, or that credit re-
straint has been much of a factor in the
economic downturn. They believe that
nonbank sources of funds have been
picking up the slack in bank lending.
One financial economist asserted that
much of the decline in credit growth
owes to weak demand for credit from
both private and public sectors of the
economy. Commercial and industrial
loans, which track closely with indus-
trial production, were growing slowly
even before the oil price shock. More-
over, bank credit has been losing market
share in credit markets since the early
1980s, well before the tighter regulatory
supervision of recent years.
Growth of nonfinancial corporate debt
slackened sharply in 1990, along with
bank lending. However, bank credit as
a share of total credit has been declin-
ing for the last several years, while the
shares of nonbank sources of credit—
especially life insurance companies,
mortgage pools, households, and for-
eign capital—have been rising. Finance
companies are one of the nonbank inter-
mediaries that have been increasing
their share of nonfinancial debt out-
standing. Portfolios of some of the
diversified finance companies include
commercial and real estate loans, which
have led to increases in nonperforming
loans and reserves for loan losses.
Another economist asserted that finan-
cial problems may extend beyond com-
mercial banks. Even insurance compa-
nies have experienced rising foreclosure
and delinquency rates for commercial
and single-family properties, especially
in New England and the West NorthTABLE 1 MEDIAN FORECAST OF CHANGE IN GNP AND RELATED ITEMS
Change in levels, billions of dollars, seasonally adjusted
1990 1991 1992
GNP in constant (1982) dollars
Personal consumption expenditures
Nonresidential fixed investment
Residential construction
Change in business inventories
Net exports
Government purchases
GNP in current dollars
GNP implicit price deflator
GNP in constant (1982) dollars
FRB index of industrial production
1990
36.8
25.9
7.2
-9.5
-20.5
11.7
21.0
5.1
4.2
0.9
0.9
1991
-7.1
-0.4
-10.0
-14.1
-2.5
14.6
5.3
4.1
4.1
-0.2
-1.3
IIIQ
14.9
18.0
10.9
-9.8
-4.8
-1.9
2.5
5.3
3.7
1.4
3.7
IVQ
-27.7
-18.8
-9.3
-7.2
-3.7
3.5
3.0
IQ
-15.6
-8.6
-7.0
-4.4
-4.9
5.0
0.4
IIQ
0.5
0.4
-3.0
-0.8
1.9
3.8
0.0
Percent change, annual
1.5
4.8
-2.6
-7.9
2.4
4.3
-1.5
-4.0
3.8
3.5
0.0
-0.8
IIIQ
25.5
11.3
2.0
2.0
3.5
4.0
-0.2
rate
6.1
3.4
2.5
2.7
IVQ
29.2
13.4
4.0
3.7
5.0
2.0
-0.4
6.4
3.4
2.9
3.4
IQ
29.7
16.7
5.0
4.2
3.5
2.0
-1.0
6.3
3.3
2.9
3.9
IIQ
30.5
16.4
6.0
3.8
2.0
0.0
-0.1
6.3
3.3
2.9
3.9
SOURCES: Fourth District Economists' Roundtable, Federal Reserve Bank of Cleveland, January 18, 1991; and U.S. Department of Commerce, Bureau of Economic
Analysis.
Central states. Finance companies, ac-
cording to one panelist, drastically cut
the number and volume of new commer-
cial real estate loans in 1990 and appar-
ently plan no lending for commercial
real estate in 1991. Similarly, both banks
and nonbanks substantially cut highly
leveraged transaction loans last year,
and many finance companies reportedly
plan to curtail that type of lending fur-
ther in 1991. An economist emphasized,
however, that funds are available and
are rising for other kinds of loans.
A finance company that specializes in
consumer credit reports that its prob-
lem loans lessened between 1989 and
1990, except for some auto dealer loans
for inventory. The company's lending
policies did not change in 1990, and the
volume of lending fell only because of
reduced demand for credit, especially
for cars.
• Outlooks for Key
Manufacturing Industries
For most of the period between 1986:IQ
and 1990:IIIQ, growth of industrial pro-
duction was stronger than growth of real
GNP, especially because of the rising
volume of exports and double-digit
growth in capital spending. The slump in
production last quarter was more severe
than for real GNP, and the Roundtable
group expects another deep cutback in
industrial output for 1991:IQ, though
less than last quarter. A pattern of mild
recovery in industrial production is an-
ticipated beginning after mid-1991, and
the pace of expected growth is again
somewhat stronger than for real GNP.
The automotive industry, which is vital
to the economy of the Fourth District,
has felt the brunt of the slowdown in
consumer spending. It now appears
that the worst of the slump in auto out-
put occurred in 1990:IVQ, when pro-
duction fell to an annual rate of 5.6 mil-
lion units, accounting for a major part
of the quarter's decline in industrial
production and in real GNP. An ex-
pected pickup in output should have a
slightly positive effect on real GNP
growth this quarter, however.
New car sales have been jarred by un-
certainties about the economy and the
Persian Gulf situation since the middle
of last year. Some industry analysts are
cautious about prospects for the upcom-
ing spring months because of a likely
increase in cars previously delivered to
rental agencies that now will be resold
to dealers and will compete with new
cars. The prospective shallow economic
recovery after mid-1991 implies no
strong revival in the auto industry later
this year and early in 1992.
In the capital goods industry, also criti-
cal to the Fourth District, the Round-
table group gave two different outlooks.
An optimistic view, based on an eco-
nomic recovery that is stronger than
the group's median forecast, shows that
business spending for producers' dura-
ble equipment declined last quarter by
much less than is typical during a reces-
sion, and will revive in the second half
of 1991. Much of the expected strength
is in high-tech industries, especially
office and computer machinery, but
strong gains are also anticipated in
transportation equipment (especially
aircraft) and agricultural machinery.
Longer-run prospects for producers'
equipment are favorable because the
aging of capital stock relative to that of
our major trading partners will require
strong growth in traditional capital
goods. A less optimistic outlook for
office and computer machinery goods
this year stems from weakness in
domestic purchases that more than off-
sets the continued growth in exports.• Monetary Policy
Some Roundtable members expressed
concern about the sluggish growth of
monetary and reserve aggregates dur-
ing 1990, and about whether their sus-
tained slow growth might prolong a
recession and dampen recovery. For
1990, the Federal Reserve set a target
range for M2 of 3 to 7 percent. Actual
growth was about 3.7 percent, although
growth in the last half of the year
amounted to a 2.4 percent annual rate.
Some financial economists urged that
the Federal Reserve move to step up
the growth rate of monetary aggregates
to the midpoints of their ranges. They
noted that the three-year trend growth
of M2 is about 4.5 percent, well above
its actual growth since mid-1990.
Moreover, nominal money balances
have been flat since last September,
and real balances have declined.
The Federal Reserve has taken several
actions in recent months, including
reductions in the federal funds rate, in
the discount rate, and in reserve require-
ments, to accelerate the pace of growth
in monetary and reserve aggregates.
Further cuts in short-term interest rates
may be necessary until money and credit
growth strengthens, according to finan-
cial economists at the Roundtable meet-
ing. In their view, a gradual reduction in
interest rates would not be inconsistent
with the long-run policy of reducing the
inflation rate.
Last July, the Federal Reserve set a ten-
tative 1991 target range for M2 growth
of 2'/2 to 6 '/2 percent. One financial
economist prefers a 3 to 6 percent target
range, leaving the lower end of the range
unchanged from 1990. He believes that
money stock growth has already been
too slow, but that the upper band should
be lowered because it is too far above
the recent trend growth of M2.
• Conclusion
The dual effects of the Persian Gulf
War and oil price unpredictability make
near-term forecasts more uncertain
than usual. What is known to forecast-
ers, however, suggests a mild, brief
contraction in economic activity and a
mild recovery later this year.
The Roundtable group acknowledges
financial strains in the economy, but
believes that some of these are structural
changes that are affecting the mix of
credit sources rather than the total sup-
ply. They generally do not believe that
credit is a serious constraint on the econ-
omy or that it will hamper a recovery
later this year because of the rising im-
portance of nonbank intermediaries that
are still making credit available, except
for real estate and leveraged buyouts.
• Footnote
1. Since the January Roundtable meeting,
the U.S. Department of Commerce has
released its advance estimate of a 2.1 percent
annual rate of decline in real GNP for
1990:IVQ.
John J. Erceg is an assistant vice president
and economist at the Federal Reserve Bank
of Cleveland. The author would like to thank
Gerald Anderson, Michael Bryan, Randall
Eberts, and Lydia Leovic for helpful com-
ments.
The views stated herein are reported by the
author and are not necessarily those of the
Federal Reserve 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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1991 outlook: mild recession, mild recovery

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1991 outlook: mild recession, mild recovery

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