A summation of the forecasts of 27 economists made at the January 26, 1990 meeting of the Fourth District Economists' Roundtable, with major emphasis on the inflation outlook, GNP growth, and capital spending.Economic conditions - United States ; Inflation (Finance)

John J. Erceg

Paul J. Nickels

English

Research Papers in Economics

March 1, 1990
eCONOMIG
COMMeNTORY
Federal Reserve Bank of Cleveland
The Economic Outlook: Growth
Weakens, Inflation Unchanged
by John J. Erceg and
Paul J. Nickels
M. here was some sense of drama in
the air as the latest meeting of the Fourth
District Economists' Roundtable, held
January 26 at the Federal Reserve Bank
of Cleveland, came to order. With the
meeting set to begin at 9:30 a.m., many
of the 27 participating economists anx-
iously perused the fourth-quarter 1989
figures released by the Commerce De-
partment just an hour earlier. Would the
numbers reflect the slowdown-without- •
recession so greatly anticipated as the
economy headed into its eighth year of
expansion?
The answer was, largely, yes. The par-
ticipating economists' median forecast
had called for a fourth-quarter real
GNP growth rate of 0.7 percent; the
government's advance estimate (sub-
ject, of course, to later revision) was
0.5 percent (see table 1). The govern-
ment's GNP price index showed an in-
crease of 3.8 percent for the quarter;
Roundtable economists had posted pre-
cisely the same median figure.
Naturally, their range of predictions
was wider. The high figure for fourth-
quarter GNP growth was 2 percent; the
low, a pessimistic -0.9 percent. The
range was equally broad for the infla-
tion figure, with predictions spread be-
tween a high of 5.5 percent and a low
of 1.9 percent.
Yet all gathered seemed to agree, de-
spite the inevitable difference in views
on specifics among economists from
manufacturing, services, and banking,
that the economic expansion is still con-
tinuing, and several key factors seem to
suggest a strengthening pace later in
1990 and beyond.
• The Consensus Outlook
The median forecast of the economy
shows a growth rate in real GNP of
about 2.1 percent from the fourth quar-
ter of 1989 to the fourth quarter of
1990, slightly less than the comparable
period in 1989. The forecasters antici-
pate growth at about a 1.5 percent an-
nual rate in the first half, to be fol-
lowed by about a 2.5 percent growth
rate in the second half, continuing into
early 1991. Only one economist ex-
pects a decline in real GNP in the first
half of 1990, with the decline to be fol-
lowed by a 3.5 percent growth rate for
the second half of the year.
Where will the expected growth in the
economy come from in 1990? The fore-
casters agreed that fixed investment
and exports will provide most of the
strength, although growth rates in both
of those sectors are expected to be less
than in 1988 or 1989. A Midwest bank-
ing economist noted that business fixed
investment and exports, which ac-
counted for 53 percent of the economic
growth between 1987 and 1989, were
The consensus forecast among econo-
mists attending the most recent
Fourth District Economists' Round-
table calls for continuing slow growth
well into 1990 followed by a more
rapid growth in output by late this
year. Little improvement is expected,
however, in the overall inflation rate
despite the current slow growth.
not expected to do as well in 1990. He
pointed to capital spending surveys for
1990 that call for a reduced pace of
spending from 1989; easing capacity
utilization rates in manufacturing; and
declines in cash flow brought about by
eroding profits as suggesting slower
growth in investment this year than last.
The merchandise trade deficit is un-
likely to improve much in 1990 and
will hold in a $110 to $120 billion
range. That view is based on the rise in
the dollar exchange rate during the first
half of 1989 and an expected slowing
in economic growth abroad in 1990.
Most of the forecasters anticipate that
consumer spending will help to sustain
overall growth of the economy, but will
not add to the growth rate. An econo-
mist asserted that consumers have built
their desired stock of durable goods, at
least for the moment, and in the pro-
ISSN 0428-1276TABLE 1 MEDIAN FORECAST OF CHANGE IN GNP
AND RELATED ITEMS
Change in levels, billions of dollars, s.a.a.r.
a
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
Unemployment rate
1989
b
98.7
61.6
21.3
-12.1
14.3
12.0
1.5
6.4
3.8
2.4
1.7
5.3
1990
b
86.7
61.0
9.9
7.8
-4.0
6.2
4.3
IQ
11,2
13.1
1.7
1.0
-8.3
2.6
-1.0
1990
IIQ
17.9
12.9
2.0
2.0
0.9
0.8
0.7
IIIQ
22.7
15.2
3.5
1.8
1.3
0.3
1.7
Percent change at annual rates
6.0
3.9
2.2
2.3
5.1
3.8
1.1
0.3
5.7
4.1
1.7
2.0
6.1
3.7
2.2
2.6
Absolute levels, percent
5.6 5.5 5.6 5.7
IVQ
29.0
16.1
4.8
1.8
2.3
1.6
1.7
6.4
3.7
2.8
3.1
5.7
a. Seasonally adjusted annual rate.
b. Calculated fourth quarter to fourth quarter.
SOURCES: Fourth District Economists' Roundtable, Federal Reserve Bank of Cleveland, January 26, 1990;
and U.S. Department of Commerce, Bureau of Economic Analysis.
cess have acquired considerable debt
relative to income. In 1990, he expects
that consumers will rely more on in-
come growth than on debt acquisition,
and income growth will slow because
job growth has been slowing.
Given these real and potential pitfalls to
economic growth, what keeps the econ-
omy from sliding into a recession?
Among the mitigating factors offered
by some of the economists was the re-
sponsiveness on the part of the Federal
Reserve, which began to ease policy in
the spring of 1989; a corresponding
acceleration in M2 growth, beginning in
June 1989; the absence of major ex-
cesses in the economy that would have
to be corrected; and a relative stability in
the services sector of the economy.
"Consumer spending on services is four
times as large as spending on durables,
and will be the single most important
factor in 1990 for recession avoidance,"
concluded a banking economist.
• The View from Manufacturing
Concern for the short run was echoed in
comments of economists representing
various manufacturing industries. A rep-
resentative of one of the Big Three auto-
makers noted that combined car and
truck sales for 1989 were down 6 per-
cent from 1988 levels and were off 9 per-
cent from the record year of 1986. Sales
fell most significantly in the Northeast
(10 percent), which has been hit by re-
cession in several of its key industries
and by declining real estate prices.
The auto economist noted that the Jap-
anese share of the American market
has continued to grow. Each of the Jap-
anese retailers had higher sales in 1989
compared to the previous year. An in-
teresting aspect of this statistic, how-
ever, was the fact that 7.9 percent of
the current Japanese market share is in
the form of transplants — Japanese
autos manufactured in the U.S. — and
that virtually all of Japan's market-
share gain in 1989 came from this do-
mestic source. "This is okay for the
U.S. economy, but bad for the domestic
auto industry," he noted.
The auto economist concluded his re-
marks by saying that the outlook for
1990 is not particularly bad, but that
profits will be squeezed and that excess
capacity will become a problem. He
laid any hopes for a significant recov-
ery on the expectation that interest
rates will decline further by the end of
this quarter. Very likely, the first quar-
ter will be the low point in sales and
production for the year.
A major manufacturer of appliances
echoed much of the automaker's con-
cerns as they related to his own indus-
try. Lower interest rates might be help-
ful, he said, while acknowledging that
lower interest rates over the past year
had not stimulated housing.
Concern for manufacturers of con-
sumer durables centers on the softness
in the housing market. An aging popu-
lation and a decline in new household
formations are hurting the purchase of
durables, such as major appliances, that
are usually associated with a strong
housing market.
The primary complaint emanating from
manufacturing is the tremendous pres-
sure on profit margins. "Inflation is not
in commodities in the long run," noted
the economist. "It is elsewhere. Prices
are down in durable goods."
Another manufacturing economist con-
curred, noting that price increases in his
market segment are "nil." This econo-
mist predicted that capital spending will
rise in manufacturing because survival
depends on it, regardless of bad profits.
"Without spending to increase produc-
tivity, industries will die in the brutally
competitive 1990s," he said.
Aging capital stock will help to support
a strong capital spending year in 1990.
Growth in producers' capital equip-
ment may nearly match 1989 levels,
and spending for industrial construc-
tion will remain strong into the mid-
1990s. All in all, growth in real nonresi-
dential fixed investment may turn out
to match or exceed that of 1989, de-
spite a mixture of developments within
that sector of the economy. It waspointed out, for example, that the com-
munications and electronics industries
will be weak in the first half of 1990
before reviving in the second half.
The manufacturing economist, reflect-
ing a view among part of the group,
credited the Federal Reserve for having
made "preemptive" moves to ease
money in 1989, thus avoiding a large
decline in the economy.
• Same Story, New Angle
The group's aggregate no-recession
forecast was lent further credence by
the latest research on business cycles,
and particularly on coincident and lead-
ing economic indicators. Two research
economists at the National Bureau of
Economic Research (NBER), one of
whom was a guest panelist at the Round-
table meeting, recently developed a pair
of new indexes that forecast growth and
turning points in economic activity.
Their experimental indexes include co-
incident economic indicators (CEI),
leading economic indicators (LEI), and
a recession index (RI).
The LEI, which includes three output
series, three series based on interest
rates, and one on exchange rates, is
used to predict the CEI six months
ahead. Because the CEI is closely cor-
related with GNP, the LEI can be used
to forecast the real GNP growth rate of
the next two quarters. Of the seven
leading indicators in the LEI, the re-
searchers found that the most sensitive
and best predictor of real GNP is the
yield spread between the six-month
commercial paper rate and the six-
month Treasury bill rate, because that
spread is affected by investors' expecta-
tion of risk of default on private debt,
which in turn will affect GNP growth.
The RI is an estimate of the probability
of a recession six months ahead. Ac-
cording to this index, the probability
that the economy will dip into reces-
sion by May 1990 is only 9 percent.
That probability is only 6 percent for
the month of June 1990, as reported by
the NBER several days after the
Roundtable meeting.
FIGURE 1 MEDIAN GNP IMPLICIT PRICE DEFLATOR
Percent change, annual rate
6
—
-
.
I
.
I
.
•*»
High
-• • •
Low
•••
1983- 1988 1989 1990
1987
IQ IIQ IIIQ IVQ IQ IIQ
1990 1991
a. Actual data.
SOURCES: Fourth District Economists' Roundtable, Federal Reserve Bank of Cleveland, January 26, 1990;
and U.S. Department of Commerce, Bureau of Economic Analysis.
Looking backward, the RI successfully
predicted each of the four recessions
that occurred since the early 1960s, but
also predicted a recession in 1967 that
did not occur.
• Inflation: Any Progress?
About the most positive development
of the past year regarding inflation was
that the overall inflation rate, measured
by the GNP implicit price deflator
(IPD), did not worsen any further. Be-
tween 1988:IVQ and 1989:IVQ, the
IDP rose an estimated 3.9 percent, vir-
tually the same as in the comparable pe-
riod for 1988. In the first five years of
the current expansion, which began in
November 1982, the rate of increase
was about 3.1 percent annually.
The Roundtable economists expect that
little progress will be made in 1990 to-
ward reducing the overall rate of infla-
tion (see figure 1). They expect that the
IDP will increase again by about 3.9
percent for the year, measured fourth
quarter to fourth quarter. They expect
transitory improvement in the second
half of 1990, but see the inflation rate
accelerating to the 4 to 4Vz percent
range in early 1991. If that median fore-
cast comes to pass, 1990 will mark the
third successive year of inflation near
the 4 percent range, even though eco-
nomic growth has slowed considerably
since 1988.
There were some encouraging develop-
ments in prices during 1989 that reflect
changes in relative prices in the econ-
omy rather than changes in the aggre-
gate price level. Producer prices for in-
termediate goods, excluding food and
energy, eased throughout 1989, and
crude materials prices, less energy,
have also been declining, although
price moderation at these early stages
of production has yet to be reflected at
the finished goods level. Spot prices
for raw industrial materials have fallen
about 10 percent since last spring.
Why do most of the forecasters expect
a persistence of 4 percent inflation in
1990 despite the several quarters of
softness in economic activity that they
project? Apparently, some believe that
a growth recession does not create
enough slack in the economy to allow
moderation in costs and prices. More-
over, some apparently believe that 4
percent inflation is generally accept-
able to the public and to policymakers,
because of the perceived high costs of
transition to lower inflation.
Alternatively, however, some in the
group believe that the anti-inflation bat-
tle is being won, and that the overall
inflation rate will recede to the 3.5
percent range over the next several
quarters. They point to the weakening
in industrial prices, and to the fact that
wage increases for both manufacturingand services workers peaked more than
a year ago.
Yet another inflation scenario calls for a
sustained inflation rate of about 4 per-
cent this year and next, but a substantial
reduction in the rate by 1992. This sce-
nario is based on the assumption that
the Federal Reserve is targeting a 2.5
percent growth rate for real GNP, de-
spite a potential output growth rate that
is estimated at about 3.5 percent
annually.
What adds to the problem of inflation
is expectations about inflation, because
people act on their expectations. In a
study of three surveys of inflation ex-
pectations, a guest panelist pointed out
that even though all the surveys over-
estimated the inflation rate for the past
several years, the different groups in
those surveys have different views
about inflation, and each group acts on
its own inflation expectations. House-
holds, for example, attempt to obtain
an inflation premium in their compen-
sation, while financial officers attempt
to include an inflation premium in their
interest rates. Inflation expectations are
relatively sticky and cannot be altered
downward easily except by policy ac-
tions, according to the panelist.
The latest information shows some re-
duction in inflation expectations during
1989, although a combination of
higher petroleum prices and rising inter-
est rates abroad contributed to an in-
crease in inflation expectations late last
year and early this year.
• Monetary Policy: To Ease or Not
to Ease
Many of the Roundtable economists ap-
parently assume a close relationship be-
tween money stock and output, and ex-
pressed a belief that monetary policy
should loosen further to foster the
higher growth in output they anticipate
after mid-1990. They expect the prime
rate to fall to about 9.5 percent by mid-
year, followed by a small increase early
in 1991. Most of the economists as-
sume a growth rate in money stock
(M2) in 1990 within a range of 5 to 7
percent, although only half would pre-
fer growth that high. Expected growth
in that high range may also explain the
expected persistence of inflation in the
4 percent zone over the next several
quarters.
Many others at the Roundtable, how-
ever, prefer money stock growth in a 3
to 5 percent range, which is similar to
the actual growth rates of the past three
years. In the view of a financial econ-
omist, this year is the appropriate time
to lower the monetary targets, despite
the high probability of a mild recession
he expects for this half. He considers a
lowering of the M2 target range for
1990 from 1989, combined with a state-
ment of support for achieving a gradual
reduction in inflation, as signals to mar-
kets of serious anti-inflation resolve
that would reduce inflation and expec-
tations about inflation.
• Conclusion
Sluggish performance of the economy
that is widely expected between last
quarter and mid-1990 should be fol-
lowed by a more rapid growth in out-
put by late this year, according to
Roundtable economists. They also ex-
pect little improvement in the overall
inflation rate despite the three quarters
of slow economic growth that is antici-
pated. It is apparent that neither infla-
tion nor expectations about inflation
have been significantly dampened as
yet by the present slow-growth epi-
sode. In suggesting further policy eas-
ing, some of the group apparently are
willing to risk the costs of higher infla-
tion in the future.
John J. Erceg is an assistant vice president
and economi&and PaurJ. Nickels is an edi-
tor at the Federal Reserve Bank of Cleve-
land. The authors would like to thank Gerald
H. Anderson and Mark S. Sniderman for
helpful comments.
The views stated herein are those of the au-
thors and not necessarily those of the Fed-
eral Resen'e 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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The economic outlook: growth weakens, inflation unchanged

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The economic outlook: growth weakens, inflation unchanged

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