The Economy -- Down But Hardly Out

Dec. 21, 2004
Economy takes its lumps, but growth will unfold through remainder of the year.

Recent data have made it increasingly clear that the unprecedented decline in profits in the last quarter of 2000 and the first quarter of 2001 will lead to substantial layoffs and higher unemployment in the second and third quarters. The unemployment rate is now expected to rise to a peak of 5% later in the year, with no gain in payroll employment until the fourth quarter. Since my outlook has been far more bullish than the consensus, this raises the issue of whether this outlook was in fact too optimistic. According to government statistics, real GDP rose at a 2% annual rate last quarter. Even with stagnant employment, I look for real growth of 2% this quarter, 3% next quarter, and 4% to 5% in the fourth quarter, when the retroactive tax cut checks are distributed. The economy is down but not out. By the time you are reading this, the Fed presumably will have cut the Federal funds rate from 4.5% to 4%, a decline of 2.5 percentage points over the last five months. Furthermore, with the economy remaining relatively weak and the unemployment rate continuing to rise, I now think the Fed will reduce the funds rate all the way to 3% later this year, matching the trough level reached in 1992. That will be enough to generate robust growth next year. Suppose employment is flat for the next two quarters. Currently, total hourly compensation is rising about 5% in nominal terms, which is about 2% in real terms. Thus consumer spending could be expected expected to rise at the same rate, if consumer attitudes do not worsen. The pessimists point to the substantial increase in the unemployment rate as a clear indication that consumers will turn more cautious, and the economy will spiral downward into an actual recession. I don't buy that argument because of the sharp drop in interest rates as well as the recovery of the stock market that already has begun and will last the rest of the year. After all, even with a 5% unemployment rate, the economy remains near full employment, and except for burnouts most people who are laid off are able to find suitable replacement jobs. Also, I'm more optimistic about the expansionary effect of the Bush tax cut than most economists. Yes, we all know what happened in the past: Reagan cut taxes and the economy went into a recession, and Clinton raised taxes and the economy went into a boom. I took some well-deserved heat from readers of this column back in 1994 when I said the Clinton tax hike would cause the economy to slow down. The all-important difference is that in 1981 financial markets reacted in horror to the Reagan tax package, sending bond rates substantially higher even as the Fed eased in reaction to the recession. Conversely, the bond markets did flip-flops over the Clinton tax hike, causing the long Treasury bond yield to decline 1.5 percentage points even though Fed policy was unchanged. This year, however, bond yields have declined as the details of the Bush tax package have unfolded, and of course the Fed has eased. There is no question that Fed Chairman Alan Greenspan, having waited too long by failing to ease at all last year, wants to minimize the chances that the economy will head into an actual downturn. As a result, the Fed will continue to cut rates as long as the unemployment rate keeps rising. Since historically that rate has been a lagging indicator, we will get further rate cuts even after the economy has started to improve, almost guaranteeing strong growth next year. The layoffs over the next few months undoubtedly will be painful to those who are involved. Nonetheless, the fact that the unemployment rate will continue to rise this quarter and next does not mean in any way, shape, or form that the economy is heading into an actual recession. Massive amounts of Fed easing will insure that this worst-case scenario does not actually occur. Michael K. Evans is president of the Evans Group, an economics consulting firm in Boca Raton, Fla.

Sponsored Recommendations

Voice your opinion!

To join the conversation, and become an exclusive member of IndustryWeek, create an account today!