January 2004
Federal Reserve Bank of Dallas

The Recovery Takes Off and the Economic Issues Shift

In recent months the recovery has taken off and the overriding economic issues have changed. Last spring the main concern was whether further monetary action would be needed to combat deflation. Today, that concern has abated, and the focus has shifted to the strength of the recovery and when the degree of monetary policy ease should be adjusted.

To shed light on these topics, I will begin by discussing how the investment and geopolitical headwinds of the early decade have died down. Next, the presentation reviews how the recovery has gained traction and momentum, with some discussion of the important rebound in profitability and the stance of fiscal and monetary policy. Then I will briefly outline the risks to the outlook, which mainly concern the pace of the economic recovery and its strength. At the end, I will summarize my major conclusions and segue to next month’s macroeconomic presentation.

The Investment and Geopolitical Headwinds Die Down
The economy of recent years has been unusual, largely because the business cycle has been exceptionally dominated by swings in business investment. While the downturn in year-over-year GDP growth—the blue line in Figure 1—has been mild in this recession compared with earlier ones, the drop in business investment—the red line—has been more on par with that of the 1982 recession—which was the worst downturn since the Great Depression. While the economy technically began recovering in late 2001, it was not until business investment began rising sharply in recent quarters that year-over-year GDP growth was at least 3½ percent.

A big factor behind the recent revival in business investment has been the sharp revival in profit growth, shown by the red line in Figure 2, which depicts year-over-year growth in inflation-adjusted, economic profits. (Economic profits are less obscured by depreciation and accounting practices than are reported or operating profits.) In most periods—such as before the late 1990s—profit growth typically leads investment growth and has a strong positive correlation after accounting for this leading tendency.

However, during the bubble years of the late 1990s, stock prices were so high that it was cheaper for companies to grow by investing in new capital than by buying out competitors at inflated prices. As a result of unusually high stock prices and excessive profit expectations, investment outstripped economic profits during the investment boom of the late 1990s when profit growth was faltering. Profitability plunged during the 2001 recession, on par with the 25 to 30 percent declines of deep recessions, like those of 1982 and 1974. Only after the Iraq War pause of the spring has profit growth notably recovered at a pace that is sustained and more in line with that seen in prior strong recoveries.

Another major headwind that has died down is geopolitical risk, which had induced pauses in spending by consumers and firms. The Institute for Supply Management (ISM) surveys purchasing managers in manufacturing about activity at their firms. Plotted in Figure 3 is the purchasing managers’ index of new orders, with a reading over 50, indicating that firms on net are seeing rising orders. This index typically plunges during recessions and historically has been a little faster to rise during recoveries than the broader purchasing managers’ index. In an earlier episode of high geopolitical risk, new orders plunged following Iraq’s invasion of Kuwait and during the first Gulf War.

The impact of geopolitical risk was very apparent in the last several years. After showing signs of recovering in the summer of 2001, new orders plunged following 9/11 and the index turned down following the president's warnings of a likely impending war with Iraq during the summer of 2002. After hopes of a peaceful resolution faded later that year, the index plunged again just before and during the Iraq War. Since then, new orders have soared to highs exceeding that of the 1983 recovery and not seen since 1950.

The Recovery Takes Off and the Outlook for Growth is Strong
As both the investment and geopolitical headwinds have died down, the recovery has gained momentum. As Dallas Fed President Bob McTeer has mentioned, it has only been since the second quarter of 2003 that we have seen two straight quarters of decent GDP growth (Figure 4). Although growth likely moderated from the torrid pace of the third quarter—when it was juiced up by large tax cuts—growth was strong at the end of last year and will likely remain so this year. A major reason is that the recovery has broadened out.

Even the manufacturing sector, which had suffered from a previously strong dollar and a secular decline, has turned up. Looking within manufacturing, virtually all the increase in output has occurred in the high-tech sector, depicted by the blue line in Figure 5, with recent signs that output excluding high tech—the red line—has begun increasing. The revival in high tech reflects the combination of a rebound in business equipment investment and increased high-tech sales to consumers.

The upturn in profits and signs that the recovery is gaining steam have induced firms to resume hiring, as reflected in five consecutive months of increases in overall payroll employment (Figure 6) and declines in initial claims for unemployment. (Although payrolls barely grew in December, some of the weakness may be temporary, reflecting bad weather during the early month data gathering period and anecdotal reports that some firms delayed hiring until the new calendar year.) Positive signals of future economic strength suggest that job gains this year will likely accelerate from their late 2003 pace.

One such sign is the plunge in the junk bond spread—the gap between yields on lower-grade and investment-grade corporate bonds—to pre-recession levels (Figure 7). Previously, this spread rose following the Russian default and then surged during the high-tech bust and amid the accounting scandals of recent years. The junk spread reflects the market’s price of taking risk on less well-established companies. A lower spread is typically interpreted as a positive leading indicator, reflecting the combination of lower market expectations of future bond defaults and a lower market price for taking on investment risk, each of which reduces the borrowing costs of many firms.

Even more encouraging is the recovery in the growth rate of the overall index of leading economic indicators following the Iraq War-related pause in the spring (Figure 8). The unevenness in the growth rate after the 2001 recession ended is reminiscent of the sluggish recovery of the early 1990s. Nevertheless, with a rebound in profits well underway, the leading indicators will likely point to strong growth for some time, barring a negative, unusual event.

One reason is that the stance of monetary policy is very expansionary. One gauge of Fed policy is whether the inflation-adjusted federal funds rate is notably above or below the 2 to 3 percent range, which is generally seen as a zone in which monetary policy is neutral—that is, neither stimulating nor restraining economic growth. If the inflation-adjusted funds rate is well below 2 percent, monetary policy can be interpreted as being easy and vice versa for rates notably above 3 percent. Whether measured using expected inflation (shown in Figure 9) or actual lagging inflation (not shown), the inflation-adjusted fed funds rate is very low, indicating that monetary policy is very easy, much as in the early 1990s.

Another factor boosting the near-term outlook is the shift in the stance of fiscal policy, which is gauged in Figure 10 using estimates of what the federal deficit would be if the economy were at full employment and relative to the size of the economy. On a cyclically-adjusted basis, the Congressional Budget Office estimates that the federal budget had shifted from deficits in the 3 to 5 percent range in the mid-1980s to surpluses around 1 percent early this decade, when policymakers entertained plans of paying off the federal debt. (Looking at nonadjusted budget numbers is misleading for gauging fiscal policy because the business cycle affects the net status of the federal budget and because the economy has grown over time.)

Since then, fiscal policy has shifted quickly and dramatically, with cyclically adjusted deficits amounting to roughly 3¼ and 3½ percent of GDP last year and this year, respectively. Many macroeconomists view the change in the cyclically adjusted deficit rather than the level as indicative of how fiscal policy affects the economy in the near-term. From this perspective, the plunges in 2002 and 2003 added much stimulus, with the slight drop this year adding some stimulus. Other estimates see fiscal policy’s impact this year as aiding short-run growth more, because tax incentives set to expire at year-end will induce firms to push up equipment investment from 2005 and 2006 into 2004. Nevertheless, both fiscal policy and monetary policy are providing substantial support to short-run growth.

Risks to the Economic Outlook
The risks to the economic outlook mainly regard the pace—not the existence—of the recovery (Figure 11). On the downside, there are concerns that growth in consumption could peter out, because households might increase saving, incur less debt, and withdraw less equity from their homes to fund spending.

Another downside risk is that a disorderly decline in the dollar could boost inflation fears and bond yields, thereby undoing some of the financial stimulus to housing, consumption, and investment. Currently, foreigners are lending an extra $1.5 billion a day to the U.S., much of which is in the form of central bank purchases of U.S. Treasuries.

The dollar could plunge if private investment sentiment shifted suddenly against investing in U.S. assets or if some foreign central banks buy less Treasury debt to keep their currencies from rising against the dollar. The dollar matters partly because a sudden decline could push up non-oil import prices (shown by the red line in Figure 12), which have an influence on core wholesale prices at the intermediate level (the blue line). Indeed, in periods when the dollar rose, such as the late 1990s, declining import prices likely restrained wholesale prices in the U.S. During and shortly following the 2001 recession, worldwide disinflationary pressures resulted in declines in both price indexes. But, owing to the fall in the dollar and the recovery in worldwide demand, import and intermediate wholesale prices have resumed rising. While the pace of such inflation is still low, a further, sharp depreciation of the dollar could change that picture.

With respect to upside risks, investment could rise more than expected should profits and the demand for new capital unexpectedly surge. Another upside risk is an orderly, but sizable further decline in the dollar, which could avoid inducing bond yields from rising, but which could greatly boost the world’s net demand for U.S. output.

Two wildcard risks are from productivity and outsourcing. In the short run, stronger productivity growth can hurt household spending by increasing job insecurity but helps the economy by bolstering profits and investment. In the long run, faster productivity growth helps job creation by increasing American competitiveness in global markets, boosting incomes and bolstering profits.

Increased outsourcing of services might also dampen household confidence not only through enhancing productivity in the short run, but also by raising the extent to which domestic labor competes with foreign labor. But by boosting productivity and competition, outsourcing also enables the U.S. economy to grow at a faster pace.

Efforts by firms to cut costs to restore profitability have likely aided recent productivity growth. Indeed, despite the slow pace of investment early this decade, productivity growth has outpaced that experienced around earlier recessions. For example, working from pairs of bars in Figure 13 going from left to right, productivity growth was faster heading into the most recent recession, during the recession, and in the seven quarters following the last recession. Other data—not shown—indicate that productivity gains are picking up in services, where outsourcing has exposed this sector to globalization. This productivity performance has vindicated the views of leading new economy optimists, such as Dallas Fed President Bob McTeer.

Conclusion
In summary, the recovery has picked up and the outlook for growth is strong because investment and geopolitical headwinds have died down; fast productivity growth will allow strong growth with low inflation; much fiscal and monetary policy stimulus is in train; and the rebound in profitability is stimulating investment and hiring.

The major upside risk to growth going forward is that profits and investment could continue surging. On the downside, a major concern is that consumption growth could fade quickly— however, an emerging job market recovery could temper the restraining effects from a possible slowdown in mortgage borrowing. Further declines in the dollar pose an unusual risk because an orderly retreat would be a plus for short-run growth, while a disorderly one might be a net minus if the impact of financial market disruption more than offsets gains in net exports. The key policy issues concern the speed of the recovery and how sustainable that growth rate is. The risks surrounding these questions warrant monitoring indicators of both aggregate supply and demand.

—John V. Duca

About In Depth This article is based on a presentation by John V. Duca, senior economist and vice president in the Research Department of the Federal Reserve Bank of Dallas. The views expressed are those of the authors and do not necessarily reflect the positions of the Federal Reserve Bank of Dallas or the Federal Reserve System.