- January 01, 1996, Robert W. Marsh
A senior economist at DuPont predicts that 1996 will look a lot like 1995, unless, of course, the unpredictable occurs.
If past is prologue, and if 1995 was a good year, 1996 should also be a good-if boring-year, according to Robert C. Fry Jr., senior associate economist at the DuPont Co., Wilmington, DE. He predicts stable, moderate growth for 1996.
Unless something unpredictable happens.
According to Fry, 1994 was "the best in ten years and featured the fastest growth rate since 1984. It had the lowest underlying inflation rate since 1964 yet provided a growth rate of 4.1 percent annual average to annual average. And it finished on a high note. The growth rate in the fourth quarter of 1994 was 5.1 percent."
That sizzling pace cooled in the first quarter of 1995, as growth slowed from 5.1 percent to 2.7 percent. Fry explains, "There were three main causes for that. The first was that the interest rate increases of 1994 finally started to impact the housing industry and the related durables such as appliances, carpeting, furniture, and paints. The second factor was the collapse in exports to Mexico. They had their peso crisis in December '94, and US exports to Mexico dropped about 20 percent almost overnight."
The third factor was a delay in tax refunds. "The IRS was trying to crack down on tax fraud, so they were reviewing a lot more returns, especially electronic returns, and they were delaying refunds," says Fry. "So, the money that people expected to receive in February or March didn't arrive until May, and that cut into discretionary consumer spending, especially on big-ticket items like cars. Those three factors cut very sharply into consumer spending. But at the same time, production stayed up, and it went into inventories. Total Gross Domestic Product [GDP] didn't drop off for that reason, which set us up for even slower growth-1.3 percent-in the second quarter."
Production then sagged, because companies that had built up inventories in the first quarter began to draw them down in the second-a classic inventory correction. In turn, companies cut production to bring inventory into line with sales.
"In the third quarter, every economist that I know of was very surprised," Fry says. "We had a 4.2 percent growth at an annualized rate. Almost all the forecasts were at 2 or 3 percent. Exports were stronger than expected, government spending-which had been shrinking for the last several quarters-actually grew in the third quarter."
A Nervous Soft Landing
Fry expects "pretty steady 2.5 to 3.0 percent growth [for 1995]. Historically, this hasn't happened very often. You don't usually get this smooth, soft landing coming down to 2.5 to 3.0 percent and staying there. So that makes us a little nervous about the forecast. But, we don't have major imbalances in the economy and, barring an oil price shock, we don't have that kind of pressure pushing us to a recession."
Instead of simply following GDP, Fry prefers to focus on industrial production, because the data are available on a monthly basis and are more timely. "It's not like GDP, where by the time you get the data it's ancient history."
But to identify a soft landing, Fry uses GDP. "You have a soft landing when the growth rate of the economy falls off but does not go negative. For example, in '67, '84, '86, and '89 the year-over-year growth rate in GDP fell below its long-term average of about 2.6 percent or so but didn't go negative. In each of those cases, industrial production actually fell 1 to 2 percent. We didn't have an officially declared recession; we had a soft landing."
But a soft landing, he warns, doesn't necessarily mean some businesses aren't going to see a decline, especially those in a volatile, cyclical industry.
As Fry explains it, "Our current soft landing is the result of manufacturing production falling about 1.1 percent over five or six months. So even though the over-all economy is positive, industrial production is falling, and cyclical industries are coming down even harder. Even a soft landing is pretty scary if you're hanging onto the landing gear. In the over-all economy, the housing industry is the landing gear. In the last four soft landings, housing starts have averaged more than a 20 percent decline. This time, they're down about 15 percent." On the other hand, he notes, the printed circuit board business is up 15 percent from a year ago.
Consumers Do React to Prices
Motor vehicle sales also dropped in 1995, due primarily to delayed tax refunds, higher interest rates, and rising prices in the first half of the year. "People react to price much more than any business person wants to admit," Fry believes. "So, demand dropped off, and in August they promoted buying incentives and had their best month in five years."
Fry thinks industrial production will grow at about a 3 percent rate in 1996, following 1995's growth rate of 3.5 percent. Also, the growth rate of GDP in 1996 is expected to be about 2.8 percent compared to 3.3 percent in 1995.
The big dropoff in housing sales has been almost totally reversed, Fry reports. "What reversed it was a drop in mortgage rates of about 2 percent. The increase in housing starts is the main reason economists have backed off on their recession forecasts. This sector always leads the overall economy. You never have a recession without the housing sector turning down first."
Short-term fluctuations in housing starts and sales tend to be related to interest rates and to recessions. But the long-term trend, Fry says, is driven by population. "People tend to create the demand for housing units when they are in their 20s. Either they buy a house, or they rent an apartment. Now, the 20-something population is declining. And so, even with a healthy interest rate outlook, we expect housing to level off at about 1.35 million units." That being the case, a reduction in interest rates may not stimulate housing appreciably.
Total payroll employment has slowed, too, but is still growing faster than the adult population. "You hear about layoffs and weak employment this year," Fry says, "but employment only fell in one month: May. The other months it was up, although it didn't grow nearly as fast as it did in 1994."
Employment growth is coming mostly from the service sector, while manufacturing employment rates fell several times in 1994, probably because of increased productivity in manufacturing. Fry anticipates growth of about 3.6 percent over the September (1995) to March (1996) period.
He thinks the Fed (Federal Reserve) may offer at least a token interest rate reduction - perhaps a quarter of a point in short-term rates - in reaction to the new federal budget. (This comment was made in November, several days before President Clinton vetoed a Republican- sponsored debt ceiling bill and before the new budget went into effect.)
He also expects the budget to include some tax cuts and a reduction in the rate at which Medicare costs will be allowed to rise, as a means of reducing the federal budget deficit.
"In the first couple of years, you'll have tax cuts that are stimulative to the economy. In the out years, most of the cuts will be in transfer payments, which shouldn't have much of a recessionary impact... The bond markets and the Fed are probably going to like this and bring interest rates down. It probably is not going to have a major contractionary effect on the economy, probably not nearly as contractionary as the cuts in military spending over the past few years. And so I don't really think deficit reduction is going to cause a recession or retard growth. In fact, it's hard to believe that our government is going to cut spending fast enough to harm the economy."
Looking at Inflation
Earlier in 1995 capacity utilization was at a five- or six-year high, something normally associated with rising inflation. Since then, industrial production has fallen and capacity has risen due to investment over the last few years. "While most capacity expansions tend to be driven by the consumer," Fry says, "this one has been driven by business investment, mostly in equipment and largely in computer equipment. So with all that investment, you had capacity growing at a pretty strong rate. Capacity utilization has dropped off. We don't see production growing quite as fast as capacity, so capacity utilization should stay at about a steady 82 percent... and much of the inflationary pressure has abated."
Due to high-capacity utilization, producer prices for intermediate materials rose strongly in 1994 and into early 1995. But very little of that rise was passed on in finished-goods prices. Another brake on inflation.
Yet, industrial chemicals prices rose very sharply in 1994 and into 1995. "You had some plant outages and strong demand around the world," Fry explains. "With a lack of capacity expansion, prices shot up. In the last few months, they've leveled off and started to come down, and, on the basis of historical patterns, we expect a small decline this year."
Core inflation (which excludes food and energy prices) has stayed between 2.3 and 3.3 percent for four years. "That's the longest period of low and stable inflation that we've had since the early 60s," according to Fry. "Inflation has stayed low even though a lot of the indicators were flashing warning signals."
How to Meet Demand
Another indicator of lower inflation is the index of vendor performance, compiled by the National Assn. of Purchasing Managers. "It's also called the index of supplier deliveries," Fry says, "and indicates how well suppliers can meet demand... the percentage of companies reporting slower deliveries. If deliveries are getting slower, suppliers are having a hard time keeping up with demand, and prices are going to go up. Normally, when this has been above its long-term average, inflation has picked up. This is the best leading indicator of inflation I can come up with. This index is now under 50 percent, so inflationary pressures have abated."
The index of vendor performance is allegedly Alan Greenspan's favorite statistic, according to Fry. He points out that since 1987, when Greenspan became chairman of the Fed, the index has come down twice. "Both times the data came out early in the month, a day or two before a Fed meeting. And at those meetings, the Fed started reducing interest rates after they'd been increasing them up to that time. I don't think that's coincidence, I think Greenspan really pays attention to that index."
In October (1995), the index was down to almost 48 percent and would be supportive of another interest rate cut. "But, they're probably waiting for the results of the budget battles to make their decision," says Fry.
Another reason inflation didn't rise in 1995 is that wage and salary costs have been under control. For example, hourly earnings are growing at about 3 percent or less, which is about the same as the rate of inflation. Concurrently, productivity has grown for the past few years, and unit labor costs have been declining.
Wages stayed under control even though unemployment was less than 6 percent. Last October it was 5.5 percent. Fry observes, "We're at a level now usually consistent with rising wage inflation and rising price inflation. And we're not seeing it this time. We may, therefore, be at the rate economists refer to as the natural rate of unemployment or the nonaccelerating inflation rate of unemployment."
Broader Measure = Better Data
Nearly all economists feel that unemployment below 5.0 percent would tend to push inflation, according to Fry.
"The employment cost index," he says, "is seen by Alan Blinder of the Federal Reserve as one of the best pieces of data to work with. This is a broader measure than the wage measure, because it includes wages, salaries, and benefits. It's growing at about 2.3 percent from a year ago. This series has been kept since about 1979, and since we've had these data, they are now at the lowest rate of increase we've ever seen."
Fry continues, "What's really interesting is that benefits had been growing at about 8 percent as recently as '88 and 7 percent as recently as '93. And that's mostly healthcare costs. In the last couple of years, corporations have gone to managed [health] care. And it works. The growth in benefits costs has plummeted. Benefits are now growing at a slower rate than wages and salaries, and that's the first time that's happened. So we're not seeing pressure from the labor market...and that contributes to low inflation."
The traditional cost-push argument states that if labor costs aren't rising (labor is two-thirds of total costs), prices need not rise, either. "I'm not totally convinced that's a good explanation," says Fry, "because even if costs weren't rising, if demand for our product was strong, you could raise prices."
"I think this contributes to low inflation is by holding down labor income and thereby holding down consumer spending," says Fry. "People can not spend, because they don't have as much money or because they're not getting big raises in nominal dollar terms. They become more sensitive to price increases. They're better shoppers, smarter shoppers, and this feeds on itself. We've broken the inflation psychology we had back in the 1970s when prices were going up and people would buy before the prices went up again. Now, when prices go up, people say no, I am going to wait for a sale or an incentive or wait for the price increase to be rescinded.
"So now inflation is much below where some of us thought it would be earlier in the year. Some of the indicators were flashing a lot of warning signals. And to the extent that inflation has come up at all, it's been a minor increase. Most of the inflation we saw has not materialized. It has stayed almost flat at about 3 percent."
US Still Leads the Way
"Some people argue that the US is no longer the locomotive of world economic growth," says Fry, "and that you've got to think broader than that. But, we still lead, and they follow."
He points out that the US economy slowed down in the first quarter (of 1995), and Europe slowed down in the second. America had a bad second quarter, and Europe followed in the third quarter. "We've started to pick up, so maybe by the first quarter of 1996, things will start to get better in Europe."
In terms of US imports and exports, Fry believes "currency shouldn't be affecting our imports and exports that much. The dollar has not been nearly as weak as you might think it has been from looking at the yen and the mark. Actually, the trade deficit has gotten bigger this year, mostly because of what has happened in Mexico. Exports to Mexico dropped 20 percent. But Japan has been weaker than we thought it would be and Europe a little weaker. They're growing only moderately. So our exports have not been as strong as some of us had hoped earlier."
The biggest determinant of a trade deficit, in Fry's view, is relative growth rates. "If we grow faster than countries in the rest of the world, our demand for imports is growing stronger than their demand for imports. So the reason that our trade deficit didn't do well this year , despite our slowdown in the second quarter, is that, for the most part, we've grown faster than the rest of the world. We've certainly grown faster than Japan or Canada or Mexico."
With No Shocks, Outlook Is Stable
All of this boils down to a rather "boring" outlook for moderate growth with low and stable inflation, says Fry. "Historically, this tends not to happen, but until there's some reason to go off in either direction, it's really the logical forecast."
Will low and stable moderate growth continue for the foreseeable future?
Yes, to the extent that the future is ever foreseeable, Fry notes. "Right now there are no big imbalances in the economy, no pressures to push it in either direction. If you look at the last four recessions, all of them were associated at least in part with oil price shocks. Two of them also had other shocks. The 1980 recession had Jimmy Carter's credit controls. In 1981 and '82 you had Volker [Paul Volker, Fed chairman] saying he's going to get rid of inflation no matter how much it hurts. Shocks like these typically cause recessions. However, the economy appears healthy enough and self-correcting enough to solve its own problems without a full-blown recession. Unless something from the outside-like an oil price shock or a collapse on Wall Street-causes severe pressures or something zaps consumer confidence, it's hard to envision a recession."
The level of consumer confidence, as measured by the University of Michigan, has been fairly stable for about the last two years. The Conference Board pegs it above where it was for most of 1994. "There's no big lack of consumer confidence right now," Fry agrees. "The confidence level tends to react very strongly to employment and unemployment. So, as long as people have jobs, they tend to be pretty confident, which is why we don't expect big drops in motor vehicle sales, because what drives motor vehicle sales is employment growth. When somebody gets a job, they need a way to get to work, and they go out and buy a car."
Fry adds, "Most recessions in recent memory have been preceded by a big runup in inflation. The recessions that started in '73, '80/81, and '90 were all preceded by high inflation and oil price shocks, and the Fed had to tighten money policy to bring inflation back down. Right now, inflation is flat to slightly down, so there's no real need for the Fed to tighten, at least in the near term. So you're not going to get a recession induced by the Fed in the conventional manner."
Corporate Illusions Can Hurt
Some economists, however, fear that low inflation could trigger a recession. "They believe that inflation will be so low that corporate earnings will not meet management's goals, even though in real terms-volume terms-corporations may be performing quite well."
When earnings fail short of targets, corporations will announce further cutbacks and layoffs, "in a sense," says Fry, "firing their customers. And if enough companies fire enough of their collective customers, they create a recession."
The major proponent of this argument, Edward Yardeni of C.J. Lawrence, expects 1.5 percent inflation in 1996. "We look for 2.9 percent," says Fry, "and some brokerage firms such as Merrill Lynch are looking at 2.4 percent. J.P. Morgan and Goldman Sachs are at 3.4 percent. Yardeni's basic message is that the pressures are there to take inflation down even further, and he's not sure that people know how to deal with that low inflation.
"What he's implying is that corporations suffer from a bad case of what economists refer to as 'money illusion': Companies only look at nominal dollars and fail to adjust for inflation. They see their nominal growth rates fall short of what they expected, when maybe in real terms they're doing fine."
Although Fry isn't convinced by the low-inflation-causes-recession theory, he is concerned that although 1996 should be "a reasonably good year... employers are not going to feel good about it. When you look at earnings growth rates, they may not be that good this year because of the slowdown last year.
"Companies tend to look at year-over-year comparisons -- that is, one quarter versus the same quarter last year. And because we had a slowdown in the second and third quarters of 1995, the first quarter of 1996 may be below the first quarter of '95, even if it's better than the last quarter of '95. Some corporations may react negatively and wonder what's going wrong. Well, what went wrong occurred two or three quarters ago, and it's just showing up in their numbers now."
Fry sees a further small decrease in short-term interest rates, while "long-term bond rates will probably level out about where they are now. Until we see some big pressures that push us one way or the other, it's hard to bet against the forecast that 1996 is going to be a lot like 1995."
Boring? Maybe, but it sure beats boom and bust.
Robert C. Fry Jr. joined DuPont's Economist's Office in 1987, following a three-year stint in Conoco's Coordinating & Planning Dept. in Wilmington, DE. There, he analyzed the impact of tax policies on Conoco and DuPont, prepared macroeconomic forecasts, and represented Conoco in drafting the National Petroleum Council study of the outlook for oil and gas. In the Economist's Office he continued to prepare macroeconomic forecasts but with special responsibility for the global motor vehicle outlook. He also analyzed the impact of the economy and economic policies on DuPont. From 1993 to 1994, he was a fixed-income analyst responsible for analyzing and modeling economic pressures on global interest rates.
As senior associate economist for corporate plans, he analyzes and forecasts global macroeconomics and its impact on DuPont. He assists DuPont businesses with interpreting economic data and using it to forecast DuPont performance. He is also the author of the monthly newsletter, "Current Business Developments."
Robert received his B.S. in economics from Ohio Univ. and an A.M. as well as his Ph.D. in economics from Harvard. He is the president of the Wilmington Economic Discussion Group and a member of the National Association of Business Economists and the American Economic Association