U.S. demand growth is accelerating to a level that will probably produce a third-quarter annualized GDP growth rate above 5 percent. During the three months ending in August, retail sales rose at a 12.1 percent annual rate; even excluding motor vehicles and gasoline, the rate was 10.6 percent. August witnessed motor vehicles sales at a rate of nearly 19 million units--the highest level since October 2001. Are we on the cusp of a sustainable recovery, or will this boomlet fade like the post-9/11 boomlet faded?

Parallels with Post-9/11 Boomlet

This quarter's surge in demand, led by consumer spending, reminds one of the powerful surge in consumer spending during the fourth quarter of 2001 that followed the crisis of 9/11. So too does the policy environment. Now, as in the fall of 2001, a disquieting exogenous shock--this time, the Iraqi conflict--has been followed by a large injection of tax cuts and government spending coupled with a highly accommodative Federal Reserve. The Fed's policies have accelerated refinancings, which, in turn, have greatly enhanced household cash flow. During July of this year alone, lower personal taxes boosted the growth of after-tax disposable income to 1.5 percent--its fastest growth rate since January 2002.

A combination of tax cuts and cash from mortgage refinancings will probably add just over $100 billion to household cash flow during the second half of this year. That increase annualizes to about 2 percent of GDP and probably will add 2 percentage points to the growth rate during the second half of 2003. Add that to an underlying growth rate of around 2.5 percent or slightly higher, and a total second-half growth rate above 4.5 percent seems likely.

The response in financial markets since March of this year has been similar to the response in financial markets to the strong demand growth that appeared at the end of 2001 after the shock of 9/11. Between November 2001 and April 2002, when markets were pricing a strong and sustainable recovery, the Wilshire 5000 Price Index rose by 23 percent, and U.S. ten-year Treasury note yields rose by 125 basis points. Meanwhile, the JOC Index of Commodity Prices rose by 12 percent, and the ISM Index of Manufacturing rose from 40 to 55. This year, over a comparable five-month period between March and August, the Wilshire Stock Index rose by 27 percent, ten-year Treasury note yields rose by 150 basis points, and the JOC commodity price index rose by about 12 percent, while the ISM index rose from 45 to almost 55.

Other parallels between the economic and market events of the post-9/11 rebound and the current rebound are striking. During the post-9/11 rebound, markets bid up stock prices and priced in substantial Fed tightening. During the spring of 2002, it was not uncommon to hear that the Fed would have to start raising rates back to neutral levels so that the federal funds rate might reach 4 to 4.5 percent by the second half of 2003. Of course the outcome was quite different. After a growth surge that peaked at over 6 percent, as initially reported during the first quarter of 2002, and that included a large inventory build-up that added 2.5 percentage points to growth, demand waned rapidly. The causes of the demand growth slowdown in the first half of 2002 were higher interest rates, which cut off refinancings, and an end to tax cuts, along with the discovery that firms had no pricing power and were not prepared to hire more workers. Further, the strong rebound in the markets of Asia and Europe disappeared with the discovery that signs of strength in those economies were tied largely to the U.S. demand growth boom through higher exports.

As U.S. demand growth faded rapidly to a 1.3 percent rate during the second quarter of 2002, thanks partly to a large drain from a surge in imports, U.S. stock prices fell sharply. Between March and July 2002, the S&P 500 fell by about a third from 1200 to 800 before bouncing briefly to 950 in August, falling back to a 780 low in October, and then oscillating around 880 for the balance of the year. Broadly, U.S. stocks lost about a third of their value after the disappointment following the false recovery of late 2001-early 2002.

The Fed eased dramatically just before and immediately after 9/11, cutting the fed funds rate in half to 1.75 percent by December 2001. For most of 2002, the Fed was convinced that its sharp rate cuts were sufficient, but by November 2002, a weaker economy and continued disinflation saw another fed funds rate cut of 50 basis points to 1.25 percent. The Fed's economic assessment of the economy was balanced after its November rate cut and remained so until an acknowledgement of weakness, specifically of concern over continued disinflation, at its May 6, 2003, meeting. Ultimately, the Fed cut the fed funds rate another 25 basis points to 1 percent at its June 2003 meeting.

Fiscal policy was also in transition during 2002. The persistent weakening of the economy that year led the Bush administration to formulate a program of tax cuts that was passed in May 2003. The timing was excellent, coming at the end of concerns arising from the Iraqi conflict and coinciding with extraordinarily low interest rates that expedited more refinancings. As already noted, the combination of monetary and fiscal stimulus boosting the economy by mid-2003 was sufficient to add at least 2 percentage points to growth over the second half of the year.

Sustainable This Time?

The major question facing markets and policymakers as we look forward to 2004 is, of course, whether this recovery will be sustainable or whether it will lapse back into substandard growth, as occurred after the post-9/11 boomlet. The question is more urgent now because few extra policy levers are left to pull. There is very little chance that the Bush administration could get Congress to enact another tax cut of any size in 2004, in light of both the upcoming election and the sharp rise in budget deficits that has occurred over the past year. Notwithstanding congressional intransigence, making the tax cuts passed this year permanent would make sense if the current recovery falters.

The Fed, having cut the fed funds rate to 1 percentage point, perhaps has a modest amount of stimulus left, but appears to have rejected the "unconventional" means of stimulating the economy with direct purchases of government securities, which appeared to have been under consideration during May and early June. At that time, the Fed voiced considerable concern about the possibility of steady disinflation turning into deflation. Now, in the wake of considerable confusion over the Fed's objectives, perhaps the best characterization of the Fed's stance is that most members of its Open Market Committee, including, of course, Chairman Greenspan, are fairly confident or at least hopeful that the economy will recover and that additional monetary stimulus will not be needed.

Unfortunately, the Fed's discussion of unconventional measures that would have to be contemplated if more monetary stimulus were needed appears to have been truncated without any resolution as to how to proceed with alternative monetary measures should the deflation threat intensify. The Fed is left in the uncomfortable position of hoping for an economic recovery, not only because that would be a good outcome for the economy, but also because it harbors serious doubts about how it might successfully re-engineer a recovery should one fail to appear after the latest round of policy stimulus.

What then is the likelihood that a sustainable recovery will result from the 2003 stimulus? Beyond some hazy assertions that the chances of recovery are better this time since we have had more time to adjust to post-bubble imbalances, the outlook is not particularly bright. It is true that most companies have reduced their capital stock to desired levels and that they are spending an amount on capital about equivalent to replacing depreciating capital. With the real capital stock being held constant, business fixed investment that measures gross capital formation has begun to rise at an annual rate between 5 and 10 percent, thus contributing between a half a percentage point and a tenth of a percentage point to growth. That is an improvement over recent years when falling capital spending represented a drag on growth.

But the outlook for capital spending is not good. Pressure on current capacity would be a signal for more capital spending and employment. The current level of capacity utilization is only 74.6 percent--well below normal. In a normal cyclical expansion, the annual growth rate of industrial production reaches 8 percent or higher as capacity utilization rises above 80 percent. Given that capacity grows at about 0.1 percent per month (according to estimates by Merrill Lynch), reaching 80 percent capacity utilization by next September would require industrial production to grow by more than 8 percent over the next year. The latest (August) reading on year-over-year IP growth is minus 1 percent. There is no pressure on capacity, and so manufacturers have little incentive to add to capital.

The growth prospects for employment are less heartening than those of investment. There is no evidence that layoffs have ceased; employment data through August show that, over the preceeding six months, layoffs are averaging about 80,000 per month, less than the 149,000 per month average of 2001, but, disquietingly, double the monthly average employment loss during 2002. Companies are still finding it possible to meet production needs with fewer and fewer workers and, in fact, helping to enhance profitability by reducing payrolls, since employment costs are about two-thirds of the total costs of a typical company.

A solid reduction in the unemployment rate from the current 6.1 percent to a reassuring 5 percent would signal sustainable growth. But, given labor force growth at about 1 percent per year, reaching a 5 percent unemployment rate by next September would require monthly job growth of 250,000 or 3 million new jobs--a far cry from that 80,000 monthly job loss average over the last six months.

Another obstacle to a sustainable recovery is global excess capacity.  Foreign producers, particularly those in Asia, are able to meet additional demand from U.S. consumers at prices that make it very difficult for managers to justify additions to productive capacity inside the United States. More specifically, China offers an almost endless supply of manufactured products at prices below break-even levels for U.S. producers operating facilities inside the United States.

On the domestic demand side, the sharp rise in interest rates that has occurred since June, even sharper than the rise in interest rates that occurred in late 2001, will end the stimulus from refinancing cashouts and lower-interest mortgages by the fourth quarter. The slowdown in growth of disposable income and lower spending on housing and attendant goods will further weaken demand growth. The demand boost from tax rebates and tax cuts will be less in the fourth quarter, since child-tax-credit rebate checks have already been mailed out, and, while lower withholding rates remain in place, they will sustain but not increase the flow of after-tax disposable income.

Balance Sheet Effects

Higher stock prices have led some analysts to suggest that stronger household balance sheets in 2003 will help to sustain demand growth. While household net worth has risen this year, especially during the second quarter, largely because of higher stock prices, it is still well below the high reached in 2000. At the end of the first quarter of 2000, household net worth stood just below $43.5 trillion, about 6.3 times income. At the end of the second quarter of 2003, household net worth stood at $41.25 trillion, some $2.25 trillion or 5.4 percent lower. The ratio of net worth to income had fallen to 5.1 to one.

The last two years have also seen a sharp increase in household debt. The ratio of household debt to GDP rose from 68.7 percent at the end of the first quarter of 2000 to 82.7 percent at the end of the second quarter of 2003, owing largely to a sharp rise in mortgage debt. Debt service payments have risen less sharply, thanks to repeated waves of refinancing at lower interest rates, but the share of household equity in owner-occupied real estate has dropped from 58 percent in 2001 to 54.3 percent so far this year. In effect, as interest rates have fallen and refinancing opportunities have abounded, households have leveraged up their real-estate holdings in response to lower borrowing costs. Going forward, however, the opportunity for further leveraging is unavailable unless interest rates drop sharply.

Consideration of a typical familiar refinancing option suggests the powerful impact of refinancing on household spending over the past year, when household debt rose by $879 billion or about 8 percent of GDP. Suppose a household has a $100,000 mortgage at 6 percent and pays annual debt service of roughly $6,000 or $500 per month. If interest rates drop to 5 percent, the household can drop its debt-service payment to $5000 per year or about $417 per month. More typically, however, households confronted by lower interest rates have elected to raise their borrowing by an amount that keeps their debt-service payments equal. In this case, the mortgage could rise to $120,000, which at 5 percent would still require $6,000 a year in payments at $500 per month. The homeowner would have an additional $20,000 to spend either on an upgrade to housing, household products, or on other consumer durables, especially automobiles. 

There is no doubt that a steady drop in interest rates, given the very liberal terms on which U.S. households can refinance their mortgage, has represented a tremendous boost to the economy, enabling households either to spend more on durables or to add to their investment in housing. Little wonder that, since the second quarter of 2000, household debt to GDP has risen from 68.7 percent to 82.7 percent, while debt service relative to GDP has risen from 13.7 percent to just over 14 percent. As far as most households are concerned, the opportunities presented by lower interest rates and liberal refinancing terms have created a steady addition to cash flow. A large part of that addition, about $775 billion over the year ending June 30, 2003, has resulted from taking out larger mortgages. This is no surprise since it makes sense to borrow more money when interest rates go down. And, a good part of the borrowing has gone into more investment on housing, but another part has gone into spending on durable goods. Whatever the outcome, the process is largely over unless interest rates return to their lows seen during the second quarter of this year or, more proximately, until ten-year yields drop back below 3.75 percent, well below the current level around 4.3 percent.

Sustainability Problems

During the post-9/11 boomlet, the dollar was strong and foreign exporters were able to increase sharply their shipments into U.S. markets. Now, after the Iraqi conflict, with substantial tax cuts and weaker growth, U.S. dissaving has increased and the potential for dollar weakness is more pronounced. However, natural dollar weakness through market forces has been prevented by heavy dollar buying from foreign central banks, particularly those in Asia that are anxious to keep their currencies from strengthening against the dollar. They hope such efforts will preserve the powerful flow of their exports into U.S. markets. The chance for a sustainable U.S. recovery over the next year would be enhanced by a weaker dollar, in effect a reflationary measure to help boost demand for U.S. goods. By preventing dollar weakness, Asian central banks may be aiding their exports now, but they are jeopardizing future growth should their efforts to prevent dollar depreciation shift too much demand away from U.S. producers and jeopardize a sustainable U.S. recovery.

Beyond the existence of excess capacity at home, one of the steady barriers to an investment recovery may be the fact that locating new capital equipment in Asia, where labor is far cheaper, is more cost effective in a world where nominal demand growth is weak and profits are difficult to come by. The continued failure of Asian currencies to appreciate against the dollar strengthens the tendency to invest in Asia instead of at home. Failing a transition to sustain higher investment and an end to continued layoffs, we may be in for a 2004 of substandard growth with virtually no policy option in hand with the exception of self-defeating protectionist measures.

From Liftoff to Orbit

There is no doubt that the U.S. economy is experiencing liftoff during the second half of 2003. We know from the experiences with the last round of fiscal and monetary stimulus in 2001 that two quarters of strong growth--this time the second half of 2003--are highly likely. Tax cuts, rebates, and refinancings provide a big boost to household cash flow, and the resulting jump in spending can boost growth to above a 5 percent rate.

But to press the analogy with rocketry a bit further, insertion into orbit--the next phase of a sustainable recovery--requires action on the part of producers to meet expected strong and sustained demand growth by investing in more capital equipment and hiring more labor. Perhaps a sharp inventory drawdown over the balance of this year will produce a sharp jump in output that, in turn, boosts investment and employment. We can surely hope for this outcome, but, based on the data available so far this year, we cannot count on it.

John H. Makin is a resident fellow at AEI.