The biggest downside risk is that the over-hyped stock markets won't make it over the valley between a stellar 7 percent-plus U.S. growth in the third quarter of 2003 and a respectable second quarter of 2004. The Federal Reserve is firmly on hold, but markets will swing--again--from wondering whether the next move on interest rates will be a tightening to whether the Fed will ease again and, more to the point, whether it will do any good. The stock market, today's manifestation of John Maynard Keynes's "animal spirits," will register the mood and tell us whether earnings hopes and the robust economy are likely to survive the withdrawal of the massive mid-2003 stimulus.

Animal Spirits

Some have suggested that a revival of "animal spirits" has already placed the U.S. economy on a sustainable growth path. If that is so, these are not the "animal spirits" of which Keynes famously spoke. Keynes saw animal spirits, not as a spontaneous way out of a protracted investment slump, but rather as a force likely to prolong slumps that, in turn, had to be offset by direct state intervention in "organizing investment." In Keynes's view, monetary policy could not be relied upon during serious slumps because depressed animal spirits meant that negative interest rates might be needed to spur spending, thereby rendering monetary policy useless, since interest rates cannot go below zero.

Keynes's warning about the impotence of monetary policy during a prolonged investment slump must have caused more than a few sleepless nights at the Federal Reserve since January 3, 2001, when the first cut in the federal funds rate from 6.5 to 6 percent was undertaken. Between that time and August 21, 2001, the federal funds rate was cut by a total of 300 basis points to 3.5 percent. After that, the first round of Bush tax cuts enacted in mid-2001 combined with another 175 basis points of post-9/11 rate cuts by the Fed to produce a consumption-led growth surge at the end of 2001, followed by sharp inventory building in the first quarter of 2002. Growth and the stock market faded rapidly thereafter, with some suggesting that the growth swoon occurred as the monetary and fiscal policy uppers of late 2001 abated.

Others, including the Fed, have chosen to conclude that the sharp slowdown in growth during the last half of 2002 and the first quarter of 2003 was tied instead to the emergence of corporate scandals in the United States, particularly in 2002, and later to the SARS epidemic that emerged in the winter of 2003 in Asia. Whatever the reason, business investment continued to languish throughout the first quarter of 2003 while consumption accounted for most of the growth.

During all of the period since the Fed began cutting interest rates in January 2001, core measures of inflation have continued to fall, with year-over-year core Consumer Price Index inflation reaching 1.3 percent in October 2003, down from an average of 2.8 percent during 2001. The steady downward grind in inflation has made it necessary for the Fed to lower the fed funds rate to 1 percent in order to push the real fed funds rate down close to zero, the same level necessary to induce growth after the recession of 1990-91.

Since the spring of 2003, another massive dose of policy stimulants has been administered to create a surge of demand in the U.S. economy that has benefited the global economy as well. The Fed's talk of deflation risks during April and May of this year created enough concern and believability to drive yields on ten-year notes as low as 3.1 percent. The period of extraordinarily low interest rates during the second quarter unleashed another wave of refinancings (including large cashouts for households estimated to have added about $150 billion to disposable income during the middle of this year).

On the fiscal policy front, government spending alone in the form of a surge of defense spending contributed nearly half of the 3.3 percent growth during the second quarter of this year. Meanwhile, tax cuts enacted in May (including lower tax rates and child tax credits) caused disposable income growth to surge at a 12.7 percent annual rate during June, July, and August. During the third quarter, the sharp rise in disposable income boosted consumption growth to a 6.6 percent annual rate of increase, contributing 4.7 percentage points of the impressive 7.2 percent third quarter growth rate.

Stimulus Wears Off

Viewed broadly, the powerful injection of monetary and fiscal policy stimulants announced in the second quarter and injected early in the third quarter could easily have been expected to produce a 5 percent growth rate during the second half of the year. The surprise came from the rapidity with which the tax cuts and monetary stimulus were spent, producing a third quarter growth rate above 7 percent. It looks as though the average growth rate in the second half of this year will still be 5 percent, only the pattern will be 7 percent or higher during the third quarter and 3 percent or lower during the fourth quarter. The first quarter of 2004 may be lackluster as well, depending upon the level of spending momentum during the holidays.

The sharp downward trajectory in growth from the third quarter to the fourth is already evident, and the resulting anxiety among investors increased by the fact that demand growth has begun to slow rapidly, while early indicators of supply growth in the fourth quarter have yet to slow. Either demand growth will have to pick up again or the supply side numbers will have to weaken sharply. The latter would probably mean a relapse back to zero or negative employment growth.

The demand slowdown is reflected in rapidly slowing spending by households.  Consumption growth peaked in August at a level well above the second quarter average then fell by 0.3 percent during September. Income growth fell even more rapidly so that the September saving rate fell to 2.9 percent--well below the 3.5 percent average of the previous twelve months and the 3.7 percent average during 2002.

October data on spending have also been weaker. October retail sales fell at a 0.3 percent rate, led by a sharp reduction in spending on motor vehicles, and September retail sales growth was revised to minus 0.4 percent from minus 0.2 percent, sharply below monthly growth figures averaging over 1 percent during June, July, and August. October sales of light vehicles were reported at an annual rate of 15.5 million units--down sharply from the 19 million-unit rate of August. Department store sales were also weak during October and into early November, as underscored by mega-retailer Wal-Mart's announcement of disappointing sales during the second week of November.

The supply side data has held up well, but that is to be expected after a huge surge in demand that caught producers somewhat flatfooted. The most heartening news from the supply side was an increase of 126,000 in the October payroll report accompanied by substantial upward revisions in previous months, totaling 144,000 jobs. As a result, payroll growth averaged 125,000 during September and October. Higher employment boosts both output and demand as incomes rise for additional workers.

Tepid stock markets and falling interest rates in November have suggested that the recent payroll numbers, as encouraging as they were, indicated only a tentative recovery. During the "jobless recovery" of the early '90s, employment growth started to improve in 1992 when it reached a minus 0.2 percent growth rate in March. As it turns out, the latest employment data for October 2003 puts the year-over-year employment growth figure at minus 0.2 percent. During the balance of 1992, monthly job growth averaged 100,000 per month, while in 1993, monthly job growth averaged 232,000 per month, as year-over-year employment growth rose from 1.3 percent in January 1993 to 2.5 percent in December 1993.

Job market performance during 1992 and 1993 provides a reminder that during that cycle the Fed's first rate increase did not occur until February 1994 when the fed funds rate was raised from 3 to 3.25 percent. At that time, the real fed funds rate (using core CPI subtracted from the nominal fed funds rate) had been at or below zero since late 1991, similar to the level since late 2001. By early 1994, the real fed funds rate was just above zero, while core inflation was around 3 percent. Today, the real fed funds rate is just below zero, with year-over-year core inflation at 1.3 percent and the nominal fed funds rate at 1 percent.

October 2003 labor market conditions are comparable to those of March 1992, which was nearly two years before the Fed initiated a rate increase in an environment where inflation was above 3 percent instead of close to 1 percent as it is now. It is not unrealistic to suppose that the fed funds rate will not be raised until well into 2005. Nor would it be surprising, given a slowdown after the growth surge in the third quarter of this year, to hear talk of the need for another rate cut by the Fed, especially if stock prices fall. Uneasiness would surround such talk as the fed funds rate at 1 percent is perilously close to zero.

While positive supply responses to the demand surge of the third quarter are indicated in surveys of manufacturing conditions, October's industrial production number suggests some moderation of the production-side response. October industrial production rose just 0.2 percent and, excluding utilities, was flat. This took capacity utilization to 75 percent--far short of the ten-year average of 81 percent, far short of the level that suggests any pressure on capacity, and even below the 2002 average of 75.6 percent.

Hope and Caution

The intensity of the demand surge during the third quarter in response to powerful monetary and fiscal stimulus is at once heartening and disconcerting. American households are clearly prepared to spend any tax cuts or proceeds of mortgage refinancings that fall into their hands, and, if the spending is intense enough, output and employment can rise. Even investment spending, which rose at an 11 percent annual rate during the third quarter, will respond. Indeed, it is encouraging, when looking at the investment spending and employment data over the past six months, to observe that the trend toward reducing employment and reducing capital equipment levels that prevailed until early this year appears to have ended. Going forward, under conditions of normal demand, companies seem content to spend enough on capital equipment to replace depreciating equipment. That translates into an annual growth rate of 6 to 10 percent, which in turn contributes about 0.8 percentage points to overall growth--slightly above the average of 0.6 percentage points over the past decade.

Employment growth going forward is more problematic. With the labor force growing at about 1 percent a year and productivity growth as high as 3.5 percent, a long-run sustainable growth rate without adding workers is about 4.5 percent. If one is a little less optimistic on long-run productivity growth, that figure may drop to 4 percent. Still, employment growth at current levels (just above 100,000 per month) is not sufficient to reduce the unemployment rate currently at 6 percent. Any slowing of the extraordinary growth of demand during the fourth quarter (which is already underway) will reduce the pressure to employ more labor going forward. At the same time, news of higher growth may pull more job seekers into the work force, boosting the rate of unemployment back up for awhile.

Fourth quarter growth may be anywhere between 2 and 4 percent depending on how rapidly consumption falls, how well investment holds up, how much government spending occurs, and whether the need to rebuild inventories is substantial and is accomplished either by domestic production or through increased purchases of imports. The domestic production route will add to growth while recourse to imported inventory replacements will reduce growth. It is hard to envision a scenario in the near future that would put any upward pressure on consumer prices, save for pressure from negative supply shocks in the food or energy sectors. Remember that higher energy and food prices function the same as a tax since households must continue to purchase energy and food--even at higher prices. If higher food and energy prices persist, spending on other categories has to fall unless consumers either cut into savings (which are already low), run up debt (which is already high), or are provided with funds from mortgage refinancings or tax cuts (which are largely behind us).

Going forward into 2004, reduced 2003 tax bills will enhance tax refunds during the first half of the year and contribute about half a percentage point to growth. During the second half of the year, the cessation of fiscal stimulus probably constitutes a modest drag on growth of about half a percentage point, but investment incentives may boost growth during the fourth quarter of the year, perhaps by 0.2 percentage points.

2004 Growth Outlook

The growth outlook for 2004 depends on an answer to this question: At what rate will the U.S. economy grow without any special stimulus to household demand from further tax cuts or from sharply lower interest rates that would lead to another wave of refinancings? The average growth rate for the economy since March 1991 has been about 3.1 percent, with two-thirds of that coming from consumption growth and the rest from modest contributions from investment and government spending. The external sector, net exports, has been a modest drag of about 0.4 percent on growth, on average, over the past decade, and that may continue to be the case unless autonomous growth in the rest of the world proceeds rapidly without the extraordinary stimulus that came from U.S. demand growth during the third quarter. The other contributor to third quarter growth was, of course, China, where annualized growth was an extraordinary 17 percent. China has experienced a sharp credit-financed boom that is probably cooling along with the U.S. economy as we move toward the end of the year.

Another source of uncertainty regarding U.S. growth going forward has to do with the degree to which foreign central banks are willing to finance American consumption. The tendency of the dollar to weaken during a period of U.S. spending growth that includes more rapid growth of imports has been blunted by heavy dollar buying from Asian central banks, particularly China and Japan. Their reluctance to allow the dollar to depreciate, or more directly, to allow their currencies to appreciate, causes more of the U.S. demand surge to spill abroad, thereby siphoning off U.S. growth potential. During a period like the third quarter when a policy-induced demand surge is helping to boost employment and output in the United States, the intervention policy whereby foreign central banks effectively help to subsidize U.S. consumption is not problematic. But if U.S. growth starts to fade rapidly, active prevention of a dollar weakening that would help to shift demand onto U.S. production would be unwelcome in the United States and would likely exacerbate the tensions already surrounding this issue.

Taken altogether it seems reasonable to suspect that growth during the first half of next year will perhaps be between 3.5 and 4 percent given the extra, largely second quarter, boost from tax cuts while growth during the second half of the year will be between 3 and 3.5 percent, provided that growth in Asia and Europe is not severely penalized by a slowdown in U.S. growth. Inflation is unlikely to rise in that environment. Indeed, the only source of higher prices--sharply rising commodity prices tied largely to increases in desired inventories of raw materials in China--could be sharply reversed if China has overbuilt its inventories and capital stock based upon the expectation that global demand will continue to be fueled by rapid U.S. demand growth. In that case, a sharp slowdown in China and Asia would reduce U.S. 2004 growth prospects to below 3 percent by the middle of the year.

2004 will be a year in which we can gauge the U.S. growth rate exclusive of any extraordinary stimulus from policy and exclusive of the downward adjustment in capital spending and the large layoffs that occurred during 2001 and 2002. Whether or not that growth rate is economically and politically satisfying and whether it is sufficient to validate the ambitious earnings forecasts for next year and thereby to validate current stock prices, remains to be seen.  Whatever the outcome, we shall not see a repeat of the policy stimulants administered at mid-year that powerfully boosted third quarter growth. We must hope that they were sufficient to have permanently overcome laggard animal spirits.

John H. Makin is a resident scholar at AEI.