LARRY Chimerine, managing director and chief economist for the Economic Strategy Institute, believes the Federal Reserve “completely misread” the economy a year ago, plunging the nation into a downturn that didn't have to be as debilitating as it was. That's the bad news.
The good news: He believes the Fed has “lucked out.”
“While they were raising (short-term) interest rates, long-term interest rates were coming down because the bond market was sensing that the economy was slowing rapidly,” he said at the Truck Trailer Manufacturers Association Convention in Orlando, Florida. “Some of the sectors of the economy you would expect to be heavily crunched by those interest-rate increases — like the housing market — haven't been hit that hard.
“Not only has the housing market kept us out of recession — by building large amounts of new houses and apartments — but we're still experiencing a huge rate of turnover of existing homes. There is no question that the Fed has lucked out so far and if the long-term interest rates had not come down sharply in the second half of last year, anticipating the economic slowdown, we would be in a deep recession right now.”
Instead, Chimerine believes that the downturn basically has reached its most severe point and the economic signals will be much more favorable by the end of the year. He characterizes the current period as “flat, slow growth on the edge of recession.
“It won't take a lot to push us down there,” he said. “But so far, things have stabilized on a macroeconomic basis. Things have not collapsed, even though, at best, we're experiencing a very slow growth.”
No Big Rebound This Year
He said most economists project a “vigorous rebound” in the second half of the year, continuing for the next several years. He said they base that on a first-quarter GNP that was much better than anticipated and surging retail sales in April.
But he doesn't believe any rebound will happen until the end of the year, largely because the high-tech overhang is so huge that it will take six months to wipe out the inventories and see an increase in orders; gasoline prices have not come down proportionately; and the rest of the world is in a “soft” stage.
“The Fed hasn't taken into account global factors in making policies over the last year or two,” he said. “We're already in a situation where rising oil prices were slowing the rest of the world economy as well, except for the energy producers. The dollar has been highly overvalued, which has slowed down US exports. We've got four to six months to work through that.”
His reasons for confidence:
— The gas spike is temporary. “The industry is already catching up by building the inventories,” he said.
— Lower interest rates will stimulate the economy.
— Tax cuts will be enacted by the fall, also stimulating activity.
— The high-tech collapse will fade out by the end of the year. “Orders will rise at a 50% rate in the next few years,” he said. “Most companies have not made all the investments they want to make.”
— The stock market is rebounding. “That's encouraging,” he said, “because it boosts confidence.”
— Consumer spending is being driven by the bottom half or two-thirds of income distribution. “For the first time in decades — because wages have picked up at the low end and because of low inflation and tax cuts — that bottom half is experiencing an increase in purchasing power and living standards. These are the people with the biggest needs and pent-up demands. We now have the highest home ownership rate in the history of the US. It isn't the millionaires who are buying up the new homes. They've already had theirs.”
Control Inflation with Productivity
He said Federal Reserve Chairman Alan Greenspan has learned something that many observers — particularly in the business sector — have believed for many years: The key to controlling inflation is productivity.
“The worst thing for productivity growth is an environment in which capital spending tends to decline and stay very weak,” he said. “Capital goods generate the most productivity. We've all done the easy stuff: laid off some workers and made workers fly coach instead of first class.
“Now the issue clearly is going to be: How do we continue this productivity explosion we've had in recent years and keep part of that as a continued high level of capital spending whereby companies are taking the new technology and replacing their old capital goods so they embody that in their productivity processes? High interest rates and slow growth economy and lots of excess capacity and weak profits all hold down capital spending.”
Chimerine said the most glaring flaw in President Bush's tax cut proposal is that it doesn't include something to stimulate capital spending.
But nevertheless, he says the tax cut is a key element of his plan to get the economy moving in the short term and make sure the country has productivity growth in the long term. The Bush Administration also needs a proactive policy to deal with the trade deficit and promote two-way free trade around the world.
“We need a full-court press,” he said. “We've been lucky in the last five years. The domestic economy has been so strong that we've been able to offset the drag from a rising trade deficit and still experience rapid economic growth. But we're not going to see the domestic economy grow as rapidly as it did in the late ‘90s. I have absolutely no idea at this stage what the administration's strategy will be on trade.”
So how did we find ourselves in this situation?
The economy, in Chimerine's words, was “singing.” He said that not only was the country nine years into economic expansion, but it also experienced an additional surge between the summer of 1999 and the summer of 2000 — an annual growth rate of nearly 6.5%, as opposed to 4% in the previous nine years. He said that prompted the Fed to continually raise interest rates on the theory that if the economy continued to grow at that rate, inflationary pressures would erupt.
He believes the Fed “completely misread” the economy during that time because most of the growth was due to temporary factors and basically was borrowing from the future.
“They were pushing spending forward so that not only would we go back to slower growth eventually, but it would probably be even below the rate of growth because some companies were accelerating their purchases,” he said, citing the effects of Y2K, unusually large and early tax refunds, and the dot-com companies' large acquisition of equipment.
“The Fed instead believed the surge in economic growth was caused by the so-called wealth effect — that the stock market had made so many people wealthier that they were taking some of their capital gains and going out to buy something. Or they didn't take the capital gains but felt wealthier because their portfolio was up sharply, so they cut other savings or accelerated their spending and didn't save as much as they usually did.
“Quite the contrary, these were temporary forces that were driving the growth surge that were going to play themselves out without interest-rate increases, not only bringing back slow growth, but probably a productivity growth rate below what we had before.”
He said there was another huge factor: Crude-oil prices were draining purchasing power because most crude is imported, meaning money was leaving the system.
Deflation
“The Fed mistook every price increase as a sign of inflation, where it really primarily is a sign of deflation,” he said. “The big impact to rising energy prices in the US comes on business costs and household purchasing power, which gets squeezed. Both of those tend to slow the economy down. On the inflation side, the most we get from it is a one-time increase in gasoline and energy prices, and then it stabilizes.
“The proper response? You could make a case that they should have been cutting interest rates to affect the deflationary impact of rising oil prices. I don't go around bashing the Fed all the time. But the truth is, they misread the economy during that period.”
He said the biggest short-term risk now is consumer confidence, because companies are accelerating their layoffs due to slower volume growth and the profit-squeezing effect of higher energy costs.
“This will be the first year that profits will be down on an overall corporate basis since 1991,” he said. “We've had a 15% annual increase in total corporate profitability throughout the ‘90s. This year, it will be down 8-9%. Layoffs are rising, and this tends to scare people. Everybody else wonders whether they're the next to go.
“If that continues and consumers start cutting back instead of maintaining the level of spending they've had so far this year, that's the one thing that can push what is now a flat economy into a recession. The risk is still there.”
His advice to trailer companies for the rest of this year:
— Plan cautiously. “I don't think it could get a lot worse, but there are downward risks for the next six months.”
— Play the productivity game. “Your industry is just as competitive as many of the others. It's just as difficult for you to raise prices as anybody else — particularly now that business is soft. You have to look for every way you can to make every activity within your organization more productive and more efficient, because you may not be able to raise prices for a long time. And as a result, if you're going to maintain or improve your profitability, a lot of it is going to have to be on the cost side. And the cost side now is productivity.”
— Be more selective. “Which of the sectors might recover more rapidly, and how can I indirectly or directly increase my share and my business in those markets?”