Underlying the golden age is an economic expansion led by unusually strong investment that produces a supply-side recovery: an economic expansion in which supply grows faster than demand so that price pressures are contained. The long period of investment growth results in sustained output growth, higher corporate profits, and a large increase in prices on the stock market. Eventually, as happened during the 1920s, a sustained rise in profits leads to a stock market bubble that pushes up wealth and demand so rapidly that the central bank eventually is forced to raise interest rates and collapse the bubble to avoid runaway inflation. But in 1996 we are still in the prebubble stage of the golden age.
With interest rates having risen by more than a full percentage point during the past two months and stock prices first stagnating and then actually falling by more than 3 percent during the week after Easter, the question naturally arises as to whether the golden age has come to a premature end. If the stock market does not go up from here, it will certainly be possible to say that the golden age never reached full flower but rather the economic expansion that began five years ago in the spring of 1991 simply ended as a result of the strains brought on by demand-growth pressures on capacity that pushed the Fed to raise interest rates in the face of rising inflation pressures.
The runup in interest rates during the two months stretching from the delights of Valentine's Day to the agonies of Income Tax Day is attributable to three sources. The first and least important is the breakdown in budget talks in Washington along with the market fears aroused by Pat Buchanan's populist campaign for the presidency. The second and probably dominant upward pressure on interest rates arose from signs of a sharp pickup in growth, underscored by a report that originally showed a payroll increase of 705,000 during February. A third source of upward pressure on interest rates comes from signs of resurgent inflation contained in sharp increases in prices of sensitive commodities like heating oil, gasoline, and grains. The price increases, at first unnoticed, have been large enough to push the Commodity Research Bureau's price index up to a level not seen since 1988.
Any phenomenon as unusual as a golden age will certainly encounter periods when its existence is seriously called into question. As I wrote a year ago,
Without the benefit of hindsight, neither a hard landing nor a soft landing nor a golden age will emerge with shining clarity. Rather, we will probably continue to oscillate between the hard-landing and the soft-landing scenarios while, if the golden age remains the underlying reality, investors in U.S. equities will continue to be pleasantly surprised, and dollar bears will be in for a rude shock.
The golden age is the exception and not the rule. Markets in the spring of 1996 are pricing the usual outcome, which has the economy running out of capacity, pushing up interest rates, and possibly ending the rapid growth of profits that has supported the stock market.
A Continuing Scenario
However, I am prepared to stick with the golden age scenario. I am encouraged by the appearance of other phenomena identified last year as part of the golden age. As I wrote then:
In a golden age, earnings continue to rise for a longer time than expected in a soft landing. As markets begin to sense extended earnings growth, cyclical stocks should begin to outperform defensive stocks.... If a soft-landing scenario gives way to a golden age, bond yields may actually rise, largely because of higher expected real returns on alternative investments rather than a sharp rise in expected inflation. The composition of inflation is important in trying to identify a golden age. Prices of raw materials ought to rise relative to prices of finished goods, as suppliers bid aggressively for inputs while productivity gains moderate the passthrough of cost pressures. Prices of precious metals ought to fall relative to raw materials prices because, while the demand for raw materials to produce more goods is rising, high real interest rates increase the opportunity cost of holding precious metals, as does the lower-than-expected inflation that accompanies a golden age recovery.
The golden age also carries implications for currency markets:
Currency markets would provide one of the most dramatic clues to the emergence of golden age. In a true golden age recovery, the dollar would strengthen for two reasons. First, the current account deficit should fall as superior U.S. productivity growth encourages higher exports and lower imports. Second, while a falling current account deficit would reduce the supply to global financial markets, sharp increases in equity prices that would accompany the golden age scenario of higher earnings of U.S. companies would begin to attract a high level of foreign capital inflows from countries without the golden age scenario. Neither Germany with its tepid demand-led recovery nor Japan with its deflationary weakness looks anything like a country in a golden age.
The sharp increase in commodity prices, relative to prices of precious metals, and the strengthening of the dollar anticipated for the golden age scenario have begun to emerge. Prices of some cyclical stocks have picked up as well. While these events certainly do not in any sense prove the existence of a golden age, they do not contradict it either. Over the past six months, the dollar has risen by more than 5 percent against the German deutsche mark and by more than 7 percent against the Japanese yen after an even sharper appreciation that began in June 1995. The twelve-month dollar appreciation against the Japanese yen is nearly 30 percent. These events were not widely expected a year ago by those holding to a view that the current U.S. expansion is a typical demand-led one.
Some analysts have correctly pointed out that part of the dollar support comes from heavy central bank buying. While the Japanese central bank has been an aggressive buyer of dollars, the German central bank has not. Further, foreign central bank holdings of U.S. treasuries, a good measure of central bank dollar buying, have increased at an annual rate of about $100 billion over the past three months, down from the $140 billion annual rate over the past six months. Therefore, at a time when central bank buying of dollars has become less intense, the dollar has continued to appreciate, indicating an increase in the private demand for dollars.
If the rise in interest rates and commodity price inflation do not mark the end of the golden age scenario, then to what can they be attributed? This question can be addressed by looking at the three proximate causes of the sharp rise in interest rates over the past two months.
Pressure on Interest Rates
The breakdown in budget talks does not supply a convincing rationale for the rise in interest rates. It was clear by early January that the budget talks had broken down, and interest rates did not begin to rise until six weeks later, in the middle of February. Beyond that, the substantive implications of the breakdown in budget talks have not in the past been associated with higher interest rates. The balanced-budget talks of late 1995 were largely aimed at trying to eliminate the budget deficit by the year 2002, mainly by slowing the growth of outlays of entitlements, particularly government health care programs. However, the negotiations concerned outlays in 1998 and thereafter. Had the budget proposal put forward by the Republicans late in 1995 actually been passed, the deficits during the current fiscal year and the next fiscal year running until the fall of 1997 would have been larger than they now will be.
The budget deficit for this fiscal year is now estimated by private analysts to be around $120 billion, down from last year's total of $164 billion and well below current official estimates of $150-160 billion. The Congressional Budget Office (CBO), ever cautious, has dropped its FY 1996 budget deficit forecast by $25 billion, to about $140 billion, about 1.9 percent of the gross domestic product (GDP). In fact, CBO's latest estimates have the 2002 budget deficit, at $107 billion, tantalizingly close to last year's target of zero.
The budget-talks-breakdown rationale for higher interest rates was replaced by the populist-fears-of-Pat-Buchanan rationale until the appearance early in March of a dramatic 705,000 estimate for the increase in February payroll employment. But, of course, Pat Buchanan did not win the Republican nomination. While he did articulate a feeling among many blue-collar workers that they are not getting their fair share of the fruits of American growth, it is not clear that those feelings are any more intense now than they ever have been. Pat Buchanan's brief rise to prominence as a possible Republican candidate for president was probably due more to his skill in exploiting these feelings of frustration than to any change in their actual level. The New York Times did wade into the discussion with a long series of articles about the anxiety and
malaise of the American middle class. But Robert Samuelson, the skilled economics writer for the Washington Post and Newsweek, undercut the Times articles with a devastating array of statistical evidence.
Analyzing Employment Data
The huge payroll increase during February probably accounted for half of the full percentage point increase in interest rates over the past two months. Although no one remarked on its inconsistency with the Pat Buchanan/New York Times malaise view of American labor, financial markets certainly noticed that the employment jump could imply higher growth. Consistent with higher expected growth, short-term interest rates rose by more than long-term interest rates so that the yield curve flattened; that is, the spread between yields on two-year and thirty-year government instruments fell from 1.3 percentage points to about 0.8 percentage points, indicating that real growth expectations, not inflation fears, were pushing up interest rates. The strengthening of the dollar that occurred during March and April was also consistent with the expectations of faster U.S. growth.
The appearance early in April of an estimate that nonfarm payrolls rose by 140,000 during March did nothing to dispel fears about an acceleration of U.S. growth. Many analysts noted that for the quarter ending in March, monthly payroll increases had risen to more than 200,000 a month, or significantly above the twelve-month average of 139,000. The unemployment rate, though it rose slightly from 5.5 percent in February to 5.6 percent in March, was still hovering at a level close to what many analysts believed would result in higher wage pressures.
A more careful reading of the employment data over the past several months suggests no such thing as an economic pickup. In fact, a combined reading of the employment data during the first quarter and other economic data measuring the growth of consumption and investment could be construed as inconsistent with the golden age scenario for an altogether different reason--not because of the possible overheating and subsequent hard landing that markets are beginning to price, but rather because of an implied shift in demand growth from investment that increases capacity to a growth of consumption, which eventually could threaten the supply-side recovery that underlies the golden age.
The payroll employment data for both February and March were totally consistent with a 1.4 percent year-over-year growth rate of employment and were down sharply from the 3 percent year-over-year employment growth that prevailed a year earlier. Year-over-year employment growth during the first quarter of 1996 was also significantly below the 1.6 percent year-over-year employment growth that appeared during the fourth quarter of 1995. In fact, year-over-year employment growth has been decelerating for five consecutive quarters since the end of 1994.
Judged from history, employment growth, having fallen below a 1.8 percent rate, threatens to continue to decelerate. Since 1960, we have never observed a drop in the year-over-year employment growth rate below 1.8 percent that did not eventually lead to a recession. Here, again, we are suggesting a threat to the golden age scenario but for reasons opposite those of the hard-landing scenario currently being priced in financial markets.
Beyond the slowing year-over-year employment growth, the total hours worked during the first quarter of 1996 actually fell slightly relative to the fourth quarter of 1995. Normally, the percentage increase in total hours worked is a good proxy for GDP growth. On the total hours worked criterion, first-quarter GDP growth would be zero. Our forecast is actually about 1.5 percent based on the momentum from year-over-year employment growth at 1.37 percent.
Notwithstanding the scare over the first quarter's employment numbers, little emphasis has been given to the fact that average hourly earnings have increased at a 2.4 percent annual rate over the past three months, exactly the rate achieved over the past six months and down from the 3 percent annual rate of the past twelve months. There is no aggregate wage pressure as yet emerging from the payroll employment reports.
Even if employment growth does not continue to decelerate and just continues at the 1.4 percent year-over-year rate achieved during the first quarter, payroll employment will actually fall by 30,000-40,000 during April. Needless to say, that number will be watched closely when it appears on May 3.
Concern about Inflation
The strongest economic signals during the first quarter are emanating from consumption spending. Retail sales--led by stronger spending on durable goods, especially automobiles, and strong spending on housing-related items--rose by close to 3 percent in real terms during the first quarter. The lower interest rates that prevailed through the first half of the quarter encouraged sharply higher housing sales and helped raise consumers' disposable income through a surge in refinancing at reduced interest rates. Lower interest rates also contributed to higher auto sales as auto financing costs were reduced in January and February. Strong auto sales incentive programs kept auto sales high during March.
Consumption growth alone will contribute about two percentage points to first-quarter growth. However, the drag from a slowdown in investment spending, weak government spending, and weak net exports will take the total growth rate during the first quarter down to about 1.5 percent. Also, the strongest component of consumption spending, retail sales growth, peaked in February at 1.9 percent and fell sharply to 0.1 percent in March. This took the year-over-year nominal growth rate of retail sales spending to 5.2 percent, about the level it has averaged for the past year.
The broad inflation indexes were well behaved during March and the first quarter. The producer price index rose by 0.5 percent in March, but that increase followed a drop of 0.2 percent during February. The March increase was concentrated in food and energy categories so that the core PPI, excluding those categories, rose by only 0.1 percent during March. During the three months ending in March, the annualized inflation rate of the core PPI was 0.4 percent, down sharply from the 1.9 percent year-over-year inflation rate. Beyond that, the deflation in core intermediate and crude goods continued.
The March consumer price index rose by 0.4 percent, but once again the concentration was on food and energy prices so that the core CPI excluding those categories rose by 0.3 percent. Both indexes remained at or below their average rates of increase over the past year. The growth scare, planted in the minds of investors by the apparently strong employment data of February and March, was underscored by a sharp increase in commodity prices beginning in March and continuing into April. Prices of wheat and corn jumped by more than 10 percent during the month, ending in mid-April, while gasoline, heating oil, and natural gas prices rose by almost 20 percent. As a result, the widely followed Commodity Research Bureau (CRB) price index rose by almost 4 percent in a month while the Goldman Sachs commodity index rose by 14 percent.
The proximate causes of increases in energy and grain prices are easy to identify. Wheat and corn prices have risen because a late spring and the lack of rain have seriously reduced the prospective supply of grains. In the energy complex, the heating oil season has been pushed by a late winter into the early driving season, so that the regular, seasonal rise in gasoline prices has been accentuated while energy prices are continuing high because of extended periods of cold weather.
The price increases are dramatic and real within the commodity markets. The operational question for financial markets is whether they are indicative of a pickup in broader inflation that, in turn, would require higher interest rates and probably lower equity prices. This remains to be seen, but so far there is little evidence to suggest a pervasive increase in inflation. Higher food and energy prices will push up the broad consumer and producer price indexes over the next few months, but it is not clear that the net impact will be generally higher inflation. Other price indexes that do not include the volatile food and energy elements like the CRB spot industrials price index, the Journal of Commerce spot index, and the Economist price index are all showing no signs of higher prices. Even the modest total inflation impact of the 8 percent increase in the CRB index over the past year will be largely offset by the 8 percent increase in the trade-weighted dollar index over the same period.
Still Sustained Growth?
No single interpretation of the path of the U.S. economy survives unjostled from quarter to quarter. Repeating again last year's observation: "Without the benefit of hindsight, neither a hard landing nor a soft landing nor a golden age will emerge with shining clarity." In the spring of 1996, a combination of higher real interest rates, a stronger dollar, and higher prices for commodities that serve as inputs for production has not shaken our conviction that we still may see a period of sustained growth over the next several years that will come, with hindsight, to be viewed as a golden age. If this scenario does come to pass, the U.S. stock market will exceed the 6,000 level we predicted for last year. And if that happens, the real danger will lie in the resulting conviction that the golden age will continue forever. It will not.
John H. Makin is a resident scholar at the American Enterprise Institute.