As anticipated in this space six weeks ago, the high-tech bubble has burst and is not likely to reinflate for quite a while. Fed Chairman Alan Greenspan claimed he wanted the superheated growth in the stock market to weaken enough that aggregate demand would not outstrip the capacity of the economy to expand. It appears he has gotten his wish. But does that mean the Fed won't tighten any more? I wouldn't bet on it. According to my calculations, real GDP rose at better than a 5% annual rate in the first quarter. If that does turn out to be the case, it will be the most rapid three-quarter gain in real GDP since 1984, when the economy was in the early stages of recovery from the longest and most severe post-World War II recession. Most of the recent surge in GDP has been due to faster growth in consumer spending rather than capital spending. Many have claimed this is a wealth effect, which means consumer spending will weaken now that the surge in the stock market has halted. But I wouldn't bet on that either. While the rise in the Nasdaq from October 1998 through February 2000 was spectacular, the surge in consumer spending started almost a full year earlier. Furthermore, it is worth noting that the two major sell-offs of the stock market in the postwar period that were not caused by sharply higher inflation and interest rates did not affect the personal saving rate. When the market plunged in 1962, the personal saving rate remained unchanged, and when the correction occurred in 1987 the saving rate rose only 0.5%. Even in the prolonged market slumps of 1973-74 and the Great Depression, the personal saving rate did not rise. It is tempting to claim that the recent rise in the consumption ratio, and the decline in the personal saving rate, reflects the sharp rise in the ratio of stock prices to GDP. Yet that development is only of recent vintage. In the 1950s the saving rate was low because of pent-up postwar demand, yet the ratio of stock prices to GDP was very low. In the 1960s a booming stock market did not translate into a low saving rate. The current stock market boom started in 1982, but it was not until 1996 that the saving rate started to decline to unusually low levels. I am hesitant to proclaim that the shift in underlying economic relationships represents a "new era," but merely note the following developments:
- Studies show that people born after World War II save a smaller proportion of their income than people born before the war, regardless of income, wealth, family size, or any other relevant economic variable. This finding indicates a decline in the personal saving rate over time, regardless of the phase of the business cycle.
- Consumer spending patterns have long been correlated with the "misery index," the unemployment rate plus the inflation rate. This index is currently at its lowest peacetime level since data started to be collected in 1890. On that basis, it is not surprising that consumers have become more optimistic.
- While interest rates obviously are not at all-time low levels, they are low enough not to impinge on consumer spending. Many auto manufacturers and dealers offer financing rates well below the prime, and the sharp drop in Treasury bond and note rates has sent mortgage rates lower even as short-term rates rise. The risks to continued above-average growth, then, are higher inflation and higher unemployment, as opposed to a stock market correction per se. Of course higher inflation would bring about such a correction, but investors also are worried about the possibility of a substantial correction that is not caused by higher inflation. I think such a development would make only a minuscule dent in the overall growth rate. As a result, the Fed will continue to push short-term interest rates higher, boosting the federal funds rate to 7% before yearend. Only then will we see a substantial reduction in the growth rate to 3% next year. Michael K. Evans is president of the Evans Group and professor of economics at the Kellogg School of Business, Northwestern University, Evanston, Ill.
