Outlook for the Economy in the Coming Year

Prof. Steven Kyle

September 2004

0. On Crystal Balls and Economists’ Projections

As ever, forecasts work well when current trends continue, they work poorly to predict turning pts. (When you most want accuracy)

             - longest recession since WW2 16 mon.

             - average = 11 mo

             - but average recession before WW2 21 months -

             - longest expansion in 90's - 8 years

             - such figures only hold until they don’ t


I. How is My Crystal Ball This Year?      At the end of last year I predicted 4% growth this year - That may be a little high but probably isnt seriously off. The year before I was predicting growth of from 1 -2% but it ended up more like around 3%. I was wrong in thinking that consumers would stop accumulating debt - They just kept right on going.

II. The Past Year

        A. NBER reported November 2001 start to current expansion. Note that the determination of an end was delayed until July 2003. This was because GDP, personal income and retail sales surpassed previous peaks while unemployment remains stubbornly high and industrial production did not pick up until the third quarter. The mixed nature of the evidence led the NBER to wait before making a decision.

        B. Signs of recovery

                - Employment - The Unemployment rate peaked at 6.4 but is it stalled? The unemployment rate is down to 5.6% from 6.4, but this leaves out all of the discouraged workers. The absolute number of jobs is still more than a million lower than it was 3 years ago. If we factor in population growth, we are way behind where we would like to be


- Industrial Production - good news for last 3 quarters

                - Wholesale/Retail Sales -The Real Question is how much debt those consumers will take on if the overall wage bill stays flat

                - Personal Income - Unemployment may have turned around, but average hours worked are still pretty low. The overall wage bill is likewise stagnant, meaning that consumers don’t have a lot more money to spend. Virtually all of the increase in income we have seen in the aggregate statistics has gone to profits and not wages. This dampens the multiplier effects we can hope for


III. Current Policy Stance


        A. Alan Greenspan keeps rates low, but they are rising - The quarter percent increases are the least we could have expected given the inflationary signs already evident

                - What will his next move be?  undoubtedly higher, but the only real question is how fast rates will rise. They should go up to 2-3 percent over the next year, depending how strong the economy looks


        B. Fiscal Policy

                - Short term outlook

                         -The biggest stimulus in history from the Feds

                                                Last fiscal year came in at 375 billion - Discretionary spending has                                                 grown at more than 12% - this year $425 billion or so

                         - Aimed at high income earners, defense and paying                          the interest on the debt (more to rich than poor)

                                     Note that the lowest 4 quintiles have received most of what they will get already - Lots still to go for the richest 20%. Interest on the debt is now almost a quarter of all spending. Lots of money gone to defense and the war - 79 plus 87 billion so far in supplementals plus more to come

                         - Offsetting state level fiscal situation or, So you                                  thought you got a tax cut? Think again.

                                                The Feds haven’t helped the states as usually happens in recession. They also have added mandates for states - The result has been steep increases in state and local taxes, in many cases more than offsetting federal cuts. New York has suffered particularly from this. (Details can be found at http://www.kyle.aem.cornell.edu/NY_fiscalfacts_10_14_03.htm) California is another big one (though the outcome is still in flux there). These two together are a very large chunk of the total, but the picture isnt happy anywhere.

                         - Twisting the yield curve

                                                The very low interest rates from the Fed together with the extremely bad long term fiscal outlook twist the yield curve to give low short term rates and high long term ones. Note that even though they look low in nominal terms, with inflation also low real interest rates are at higher than average historical levels..

                - Long term outlook

                         - Fiscal train wreck

 Latin American analogies are entirely appropriate. The world has never seen the country with the reserve currency behave in this manner before. It is reckless and irresponsible.

                         - Higher interest rates

These are inevitable whenever foreigners get tired of funding our excesses. These will also have to occur to offset any depreciation of the dollar.

                         - One sure thing - Something will change before                                  2010

IV. The Big Question - Where are We Going Now?

        A. The Case for Happiness

Consumer sentiment is looking better - Both Conference Board and U. of Mich. indices are up compared to a year ago but down in August compared to July - BUT!!! note the number who think country is headed in wrong direction.

                        - Good GDP figures but slower than expected

Third quarter last year was great. Since then things have been rather lackluster for what is supposed to be the boost phase of an expansion

                - Employment picking up (some)

Jobless claims seem to be improving though there is as yet lots of slack in the labor market

        B. The Case for Caution

                - If Consumers are Going to Spend, Where Will They Get                          the Money?

                         - Employment numbers - the pessimistic view

The employment to population ratio is very low - Lots of people are without jobs and the jobs many have arent very high quality. More importantly, most of the increase in income in the past year has gone to profits and not wages, limiting the money people have in their pockets

                         - Those puzzling productivity numbers

                                                Though output has grown, hiring has stayed flat. This necessarily implies that productivity has gone up. (Note that productivity is never measured directly - it is always inferred from production and employment numbers - hence there is always the possibility that there is a measurement error somewhere). Either employers will have to start hiring soon or consumer spending will cool off - Current trends can’t go on indefinitely. Recent research shows that much of the change in employment in this business cycle has not been cyclical in nature but has been the result of long term restructuring of the economy. That is, many of the jobs lost during the recession aren’t coming back.

                         - Those troubling consumer debt numbers

                                 They have just kept on going up and up. Lower interest rates mean that monthly payments don’t have to go up even though debt does. But this can turn into an unhealthy backlash when rates eventually do go up. As Herbert Stein said, “Things that can’t go on don’t” (or something to that effect)

                         - Housing - The Peak is here (sell now)

                                 Housing usually peaks 1 - 3 years after the market - or around the time interest rates start back up again. This is happening now. An added factor here is that housing is more directly connected to consumer spending than it ever was in the past through the home equity loan market.

                         - Those P/E numbers look more reasonable than a year ago but still high

                                 They are lower than at the height of the bubble a couple of years ago but with the P/E of the S&P 500 in the low 20's they are predicting higher bond yields and/or somewhat lower?? stock prices. It is also still well above the historical average. But the NASDAQ P/E is still in the neighborhood of 30 even when you exclude all of the negative numbers for those companies not making a penny

                - Will Business Investment Drive the Recovery?

                         - Capacity Utilization - Still in the 70's

                         - If they were confident they’d be hiring more

                         - Still, the latest business investment data is good

                - Will the Foreigners Help Us Out?

                         - Foreign Business Cycle News - China puts the brakes on while Europe is mixed - Germany low growth.

                         - The Exchange Rate - One way bet - With half a trillion new dollars going out into the world every year - about $2 billion every working day, the dollar is likely to fall more since the long term outlook is for a worsening and not an improvement of this situation

V. Opinions from Where I Sit

        A. Growth

 I expect the rebound to continue but at plodding pace. The third and fourth quarter figures are likely to come in with growth lower than the first half of the year. Stimulus from the Federal government will continue though more heavily biased toward upper income brackets, thus muting its expenditure effects. The big question is whether interest rates will rebound substantially, creating a sharp retrenchment.

        B. Inflation


There is some evidence of inflation beginning to be apparent but there is little danger of a major spike in the very near future, especially given the continuing slack in the labor market, and the low levels of capacity utilization. Nevertheless, the continuing very low interest rates (though on the increase) will provide continuing pressure. Another major question mark is the exchange rate. Should the dollar go down sharply, some degree of inflationary pressure will result. Finally, oil prices are a big question mark - they are currently very high but the Saudis have said they will fix this by the time of the election


It’s hard to see a huge boom in stocks given the current P/E levels.

                        Housing Prices

It is likely that this bubble has reached its peak now that interest rates are starting back up. Given the lack of inflation, we may see an actual decline in house prices. There are already signs of slowdown in the market. Housing starts in April went down and the rise in rates since then coupled with the expectation of more to come should prove a damper as well.

            C. Interest Rates

Alan Greenspan wants to raise rates slowly His pattern is to do it a quarter percent at a time. That is what I expect through fall, particularly since he doesnt want to be seen as trying to influence the election. But if there is a spike in inflation or a drastic drop in the dollar he may have to be more aggressive. The longer he can hold off, the better for fighting deflation as well as putting the brakes on spending, since it is still not obvious that we have a healthy recovery A possible fly in this ointment would be a precipitous dollar drop. While it would have to be a drastic situation for domestic monetary policy to move as a result, interest rate hikes to protect the dollar arent entirely out of the question.