"Ill blows the wind that profits nobody."
--Shakespeare, Henry VI, Part III (act II, scene 5, line 57)
The prolonged period of geopolitical uncertainty surrounding the onset of the war on Iraq has made the Federal Reserve resemble the United Nations as a body of ditherers in the face of a need for action. During the weeks since Fed chairman Greenspan's February 11 declaration to the Senate Banking Committee that additional stimulus is not needed to get the U.S. economy past the mushy swamp once called a "soft patch," the economy has weakened more rapidly than at any time since the early weeks of the recession that began in March 2001. The response of the Fed's Open Market Committee (FOMC) after its March 18 meeting was to declare that "the Committee does not believe it can usefully characterize the current balance of risks with respect to the prospects for its long-run goals of price stability and sustainable economic growth." For those left aghast at such remarkable indecision (on the prior day, private forecasters had cut their growth forecasts in half for the entire first half of this year), the FOMC added: "In the current circumstances, heightened surveillance is particularly informative."
We must hope that this nonsensical statement--when is heightened surveillance not informative?--was only a clumsy effort to obscure a sharp division on the committee between those who wish to ease further and those, Chairman Greenspan most prominent among them, who believe that the invasion of Iraq and its aftermath will do wonders for the economy. "Heightened surveillance" probably means another 50-basis-point rate cut by the FOMC in April, before its next meeting on May 6.
The Fed's inaction in the face of a weakening U.S. economy is made even more dangerous by the fact that the other potential source of stimulus--tax cuts--has stalled in Congress. Senate "moderates" like Olympia Snowe (R-Maine) decry larger deficits that might follow from tax rate cuts for their constituents while simultaneously proposing additional outlays of $40 billion on state aid. Ms. Snowe and others in Congress listened only selectively to Chairman Greenspan when, indicating the concern over budget deficits, he suggested that tax rate cuts ought to be accompanied by spending cuts. The upshot is that like monetary policy, fiscal policy is on hold too, hostage to the amount of political capital that President Bush will have on hand after the war on Iraq.
War, however necessary, is an "ill wind" but it can nevertheless profit the global economy by beginning the painful and difficult process of containing rogue states and terrorists. A secure and stable world is a necessary condition for modern, interdependent economies to survive and prosper. Geopolitical threats act like a tax on the global economy, and their removal increases the long run potential for growth. However, for the short run, the initiation of war has dangerously delayed the enactment of more policy stimulus for the U.S. and global economies, both still mired in a post-bubble malaise.
Markets Simulate a False Dawn
The onset of the war on Iraq triggered a relief rally that sent stocks, interest rates, and the dollar higher as oil prices fell. Earlier, at the onset of the First Gulf War in January 1991, stocks rallied, with the S&P Index rising about 20 percent over the three weeks following the outbreak of the brief hostilities. The price of oil fell by a third, from about $30 to $20 per barrel while the price of gold fell about 10 percent from $400 per ounce to $360 per ounce. The dollar fell briefly against the yen and the Deutschemark and then rose--especially against the mark--by about 15 percent. U.S. interest rates on ten-year notes at first fell by about 30 basis points from 8.1 percent to 7.8 percent and then rose back to prewar levels by late February 1991.
In retrospect, it was discovered that during the winter of 1991, the U.S. economy was starting to exit a recession that had begun in July 1990. U.S. interest rates continued to fall after mid-1991 as the U.S. entered the "jobless recovery" of 1992 and 1993, and ten-year yields fell below 6 percent by early 1994. The Fed had to cut the federal funds rate sharply, by 500 basis points, between late 1990 and August 1992 to sustain the recovery and even then endured an entire year of tepid employment growth in 1993.
The economic and geopolitical situation in the spring of 2003 is more complex then it was in the winter of 1991. Geopolitically, the United States is embarking on a long-term effort to contain global terrorism emanating from rogue states like Iraq and North Korea. The stakes are higher than they were in the brief war aimed at expelling Iraq from Kuwait. The risks are considerably higher.
Underlying economic conditions are more complex too. In 2003, the world economy is still in a post-bubble environment struggling to escape a prolonged period of low nominal growth that will not support enough profit growth to trigger a rise in stock prices. A danger exists that a relief rally accompanying successful execution of the war in Iraq and an absence of new terrorist acts and destruction of oil fields will boost the dollar and push up long-term interest rates rise by a quick 100 basis points. That reaction, in effect simulating a recovery while demand remains weak, would choke off sustainable growth.
The post-September 11 relief rally saw the S&P Index rise by 20 percent during the fourth quarter of 2001. Amid widespread expectations of a sustainable recovery during the first quarter of 2002, the stock market held on to its gains as the economy grew at an annual rate of 5 percent (first reported as above 6 percent). Yet, ominously, a rise in inventory accumulation accounted for more than half of that growth. And interest rates on ten-year Treasury notes, which had risen by 90 basis points from 4.2 percent in October 2001 to 5.1 percent at year end, pushed to a high of 5.4 percent by the end of March 2002. Thereafter, growth fell sharply to a 1.3 percent annual rate in the second quarter of 2002. Moreover, stocks collapsed along with interest rates during that quarter. Specifically, the S&P Index fell by more than 40 percent, from 1150 in March 2002 to 800 in July 2002. Ten-year Treasury note yields fell 180 basis points from 5.4 percent to 3.6 percent in September 2002. By November 5, 2002, the Fed found it necessary to cut short-term interest rates by 50 basis points from 1.75 percent to 1.25 percent. Fourth quarter growth-after a brief consumption--led jump to a four percent annual rate during the third quarter--slumped to 1.4 percent, and half of that growth came from higher government spending.
The U.S. economy needs stronger, sustainable demand growth to escape from the stop-go pattern exhibited in 2002. The underlying problem lies with the sharp rise in real interest rates (inflation is steady to falling, save for cost pressures from higher energy prices and prices of some industrial commodities that compress profits) that occurs when money chases up stock prices buoyed by recovery hopes. Demand growth (driven by refinancing) slows, and without a steady diet of tax cuts and lower rates, stalls out. In 2003, the tax cuts have run out, government spending growth and tax cuts will slow, and oil prices will avoid being a drag only if they fall back to a range of $22 to $25 per barrel.
The Real Economy Is Weaker
Since early February 2003, the deterioration of the U.S. economy, measured by economic surprises (economic releases that are either stronger or weaker than forecast) has been even more rapid than last fall's deterioration. That weakness produced 50-basis points of Fed easing early in November, the effect of which was brief and tepid in the form of a small bounce of demand growth over year-end and into January.
The slowdown since January has been concentrated on the demand side, with sharply lower consumer confidence and retail sales, including much weaker auto sales that have already resulted in lower auto production schedules for the second quarter of this year. As demand growth has dropped sharply, employment too has been sharply reduced with a drop of 308,000 in February, bringing the average employment loss over the three months ending in February to 90,000, close to the loss of 119,000 per month that occurred during the recession of 2001. While about 90,000 of the payroll reduction in February could have been attributed to reservists called up for military service, a net employment drop of more than 200,000 in February was still more than 200,000 worse than the consensus forecast that was made with the full knowledge of reservists, call-ups, and weather problems.
The deluge of "surprisingly" weak economic numbers over the past month renders somewhat moot the role of geopolitical uncertainty in determining the path of the economy. The economy has already lost considerable momentum. Retail sales excluding motor vehicles and gasoline fell at a 1.2 percent annual rate over the three months ending in February. That brought the year-over-year growth rate to 1.9 percent, about half the growth rate of that category in 2002. As a result of sharply weakening demand growth, the broad indicator of momentum in the factory sector fell to 50.5 in February, suggesting virtually no growth in that sector, and it will likely fall below 50, suggesting contraction, when the March figure appears on April 1.
Will a successful attack on Iraq, after the dust settles and interest rates and stock prices are higher, make households buy more automobiles and firms add further to capacity? I doubt it unless the outlook for profits improves, and that will require sustained nominal growth well above 5 percent. Geopolitical uncertainty has persisted long enough to administer a sharp negative shock to the U.S. economy and to U.S. households and producers. The onset of war with Iraq is no shock, having virtually been promised for weeks by President Bush. The conduct of that war, and the attendant problems associated with rogue nations like North Korea and possible terrorist acts, will leave the level of geopolitical uncertainty elevated for some time to come. Once the economy experiences the kind of sharp loss of momentum it has suffered over the past two months, the risk of recession is sharply elevated.
A Broad Post-Bubble Pattern
While I do not expect the United States to become the next Japan, mired in a persistent deflation without growth, the parallels to the unfolding of the post-bubble period in the United States with those in Japan are disconcerting. After about three years of weak investment growth reflecting the excess capacity that developed during the stock market bubble, U.S. consumption has started to weaken rapidly. The slowdown in consumption is tied to weak nominal growth and weak profits growth that forces firms to cut costs by reducing labor. The negative pressure on labor markets lowers incomes and in turn reduces consumption. If a consumption slowdown becomes too pronounced, another round of layoffs and weakened investment is required to adjust to lower demand growth.
Simple bad luck is very dangerous in such an environment. An unusually cold winter, heightened geopolitical uncertainty, and other events that provide excuses for inaction by policymakers produce a situation where one round of bad luck creates another, where, say, unusually bad weather or an unusually volatile geopolitical situation freezes policymakers into inaction.
Part of the difficulty now faced by the U.S. and global economies in exiting the weak growth path before a recession develops lies with the fact that quantifiable negative exogenous shocks have already overwhelmed the scale of fiscal and monetary stimulus currently contemplated. The rise in oil prices by nearly 60 percent from $26 a barrel as recently as November 2002 will probably subtract about 0.5 percent from GDP growth over the coming year. Should the price of oil go back to $26 a barrel or lower, that drag could be eliminated by the second half of the year. Meanwhile, state and local government finances are weak enough to suggest a drag on the economy--again worth about half a percent of GDP by the second half of the year. Even if the full fiscal stimulus package proposed by the Bush administration were passed by summertime and made retroactive to January, thus providing about 0.8 percent of GDP stimulus to the U.S. economy, it could nearly be offset by the drag from higher oil prices and weaker state and government finances.
What is perhaps most disconcerting in this environment where exogenous forces have frozen policy stimulus is to realize that the tepid 1.4 percent growth rate during the fourth quarter of last year came with the help of powerful stimulus. The Federal Reserve has estimated that mortgage refinancings enhanced household income at an annual rate of $320 billion, or more than 3 percentage points of GDP, during the fourth quarter. Simultaneously, interest rates were falling and the Fed cut short-term rates further by 50 basis points early in November. And the Bush administration was promising tax cuts on an order of 1 percent of GDP late last year. In the face of all this stimulus, the U.S. economy managed only a low rate of growth and even on a year-over-year basis that captured the stronger growth earlier in the year, nominal GDP grew just over 4 percent--a rate insufficient to generate profits. Clearly, much of the money coming out of refinancings is either going into savings or paying down expensive credit card debt or both.
A New Monetary Policy Regime?
Late last year the Federal Reserve addressed the issue of what it would do if interest rate reductions close to zero did not result in higher economic growth. Fed governor Benjamin Bernanke's speech about the option of having the Fed purchase longer-term securities received a great deal of attention as well it should have. One hopes, however, that the Fed's intention is not to reduce interest rates nearly to zero, say to 50 basis points (only 75 basis points below the current level) and then start to debate whether or not purchasing longer-term securities and moving to a money growth target is the appropriate policy. In an environment where inflation and growth are low enough to force the Fed to contemplate a money growth target rather than an interest rate target, a believable target of price stability with inflation in the zero to 2 percent range can be very helpful in avoiding a deflationary meltdown. Unfortunately, the Fed, and in particular Chairman Greenspan, have shown little willingness to contemplate a specific inflation target. Perhaps that will change if further interest rate reductions are accompanied by continued low inflation and low nominal growth of the U.S. economy.
Ill Wind May Profit Many
Geopolitical uncertainty, bad weather, and other external factors have all hurt the U.S. economy as it struggles to emerge from the difficulty of a post-bubble environment. Continued stagnation in Europe and Japan has been another serious problem. But it is time to recognize that the damage of prolonged negative exogenous forces such as geopolitical uncertainty is already great enough to justify a rapid move to additional stimulus on both the monetary and the fiscal fronts and both in the United States and abroad. If the beginning of the war in Iraq speeds up that process, then progress on the economic front will accompany hoped for progress on the path toward a safer world. An ill wind will have profited the world economy.
John H. Makin (jmakin@aei.org) is a resident scholar at AEI.
