It is clear that the U.S. economy is continuing its gradual slowdown that began in the second quarter. While there are many explanations, including uncertainty caused by the delayed resolution of the presidential election, we believe it is substantially a result of the actions this year by the Federal Reserve.
Consider the stock market. Shifting valuation paradigms and a reversal of "momentum" have combined with the ill effects of "tightening" to undermine enthusiasm for equities. Most institutional money managers we talk with have reached a consensus that broader stock market averages will return 5% to 8% annually over the next few years and most are increasing the weighting in their portfolios to alternative asset classes. Their conclusions, if correct, are especially thought-provoking when this yield range is assessed on a relative, risk-adjusted basis. If corporate earnings decelerate at a faster rate than anticipated, do stocks feature attractive intermediate-term value?
The economic data over the past month paint a picture of an economy that slowed abruptly during the second half.
Third-quarter real gross domestic product was revised downward to a 2.4% annual rate, versus the 2.7% pace estimated last month - the slowest growth since the fourth quarter of1997. The productivity of American workers rose at a slower pace than in the prior three months, while labor costs accelerated more than expected. Both factors - rising unit labor costs and declining levels of productivity - are classic indications of an economy in the second stage of an expansion cycle.
Consumer purchases account for about two-thirds of the nation's output, underpinning a U.S. economic expansion now in its record 10th year. But adjusted for inflation, consumer spending was unchanged in October, the weakest showing since July 1998. Unemployment-claims data released in November suggest that the labor market has softened considerably. First-time jobless claims rose by 19,000, to 358,000, the highest since early July 1998.
The current slowdown is a classic inventory correction brought about by the Fed's tightening of the credit markets. Fed Chairman Alan Greenspan acknowledged as much this week, saying that "the pace of expansion of economic activity has moderated appreciably" and that "tighter financial conditions have had some impact on interest sensitive areas of the economy." Diminished business spending has led to cutbacks in production, with third-quarter industrial output dropping to its lowest level since the beginning of 1999.
Remember the "wealth effect" that so concerned Mr. Greenspan, and was a major driver behind the Fed's tightening? We are now witnessing the other, unintended consequence of that policy: The increase in interest rates has caused the dollar to strengthen, creating further financial problems for global corporations.
Here's the sequence we are witnessing: the Fed tightens stock prices decline consumers react by cutting spending corporate earnings growth slows stock prices decline further. At the same time, the Fed tightens; the dollar increases; corporate earnings growth slows; stock prices decline even more. This could be a downward spiral, but luckily the fluctuation in stock prices has been but one of the many influences on consumer spending.
The effect of higher labor costs, high material costs, a stronger dollar and, in the case of multinationals, a weakening euro will continue to strain corporate earnings. Improvement in productivity is a key reason the economy has been able to grow faster without causing inflation to accelerate. The lower productivity levels exhibited this past quarter may persuade the Fed that productivity gains will no longer offset labor and material cost increases. Also, higher levels of compensation that remain unchecked by productivity gains threaten inflation, which will result in a conflict as the Fed is forced to choose between its two foremost objectives: sustaining output and fighting inflation.
Many have argued that the Fed went too far in its effort to slow the economic growth when it raised the overnight bank lending rate six times between June 1999 and May 2000. We are now feeling the consequences of a policy that left little room for error.
The market's worst fear is being realized: that a slowing U.S. economy will hinder corporate earnings growth. In November alone the Nasdaq fell 23%, concluding the worst month for the index since the 1987 stock market crash. The Dow Jones index fared somewhat better, down about 5% for the month. This carnage has left many investors hoping the Fed will lower interest rates early in 2001.
While this outcome is likely, Mr. Greenspan's comments this week detract from the notion that the Fed's predictions have solidified. "Still, in an economy that already has lost some momentum, one must remain alert to the possibility that greater caution and weakening asset values in financial markets could signal or precipitate an excessive softening in household and business spending." But Mr. Greenspan also noted that energy prices have increased "at a 40% annual rate since the spring of 1999." Furthermore, he added, "If accommodated by monetary policy, the jump in energy prices could spill over into general inflation and inflationary expectations, as was evident in the 1970s."
One thing is clear: the economy will remain in a slowdown through at least the first half of 2001.
The remaining question is how hard the landing will be. It is now not a question of eventuality, but one of degree.
Mr. Dailey is president and chief exectutive officer of Dailey Capital Management in Southport, Conn.
