Council of Economic Advisor Meeting
February 21,2002 - Orlando, Florida

Current and Future Outlook for the US Economy
Russell P. Chuderewicz

Positive Developments
Index of Leading Economic Indicators on the rise – significant in that empirically, especially in the short-run, the index does quite well as a predictor of real output. Keep eye on the two negative contributors - manufacturers' new orders for non-defense capital goods (significant for productivity in the longer – term) and manufacturers' new orders for consumer goods and materials.

No Inflation Anywhere – Producer and Consumer prices have been extremely well behaved. Good for real purchasing power (real wages). Fed Policy can remain loose and perhaps get looser if need be. Bad news, firms lack pricing power – profit outlook cloudy.

Effects of Fed Policy will be kicking in – given the considerable effectiveness lag in monetary policy, the economy will enjoy the influence of the Fed easing throughout 2002.

Flexible Labor Markets - given weaker unions, firms are able to hire and fire more freely with out union restraints. According to Bradley Schiller “Weak Unions Create a Strong Economy” (WSJ 02/19/02), the result is that firms will turn to new hires to “ratchet up production” when demand picks up. He goes on to argue that employment will rise as quick as it fell, speeding up the recovery. Also significant is the expanded use of outsourcing. When demand picks up, production will pick up across a swath of industries increasing employment in a very broad sense.

New Economy is Alive and Well - Productivity gains have held up extremely well during this downturn implying that the slowdown is clearly a demand side phenomenon. As we know, productivity gains are the key to increased living standards. From a policy perspective, strong productivity gains allow the Fed to keep rates low.

Inventories have Adjusted – the so-called unintended business inventories have fallen to a point where firms will need to increase production and thus employment when demand strengthens.

Fiscal Policy is Expansive - we have had some stimulus from Fiscal authorities with more possibly to come. I think it is likely that unemployment benefits will be extended and we will see more (expansionary) stimuli from the Federal government with the exact form uncertain at this point.

Consumer Confidence on the Rise – although the recent report from the University of Michigan was a little disappointing, especially in the expectations component, consumer confidence has been well behaved and on the rise.

Strong Housing Sector – Low Mortgage Rates. Along with the US consumer, the housing sector has remained a pillar during this economic slowdown. Low mortgage rates also result in a significant amount of home re-financing leading to increased consumption.

Lot’s of Liquidity in US Markets – Given the global slowdown, most feel that it will be the US economy that will turnaround first. The result is that much of the world’s liquidity is already in US markets or on the sidelines ready to enter at anytime (consistent with the super strong dollar). The liquidity is important for jump starting investment via corporate bond and commercial paper issuance as well as boosting the equity markets and thus consumption via the wealth effect.

Concerns

Credit Crunch – More than a few firms are currently having trouble tapping the all important commercial paper and corporate bond markets. Sprint, for example, is now paying 4.35 percentage points above comparable Treasuries, a yield of over 9%. We hope that this accounting scare doesn’t result in contagion, which may result in firms falling back on their previously established lines of credit. Although we should be thankful for the diverse credit markets that we enjoy in the US, falling back on one’s line of credit often results in downgrades by rating agencies which would exacerbate the credit crunch. Qwest and Tyco recently were prevented from tapping the commercial paper market due to the accounting scare. The Fed is currently keeping a close eye on these interest rate spreads.

High Long - Term Real Rates of Interest – the 10 year bond has hovered around 5 % recently and with inflationary expectations around 1.8 %, results in a real rate over 3%. According to economic theory, the long - term real rate is the rate that matters and I am sure Greenspan would love to see these long rates fall. The possible good news is that this results in a steep yield curve, a phenomenon that would be argued by some as an indicator of subsequent economic growth.

Dollar Very Strong which works against the exchange rate channel of the monetary transmission mechanism. Since the Fed started easing, the dollar has gotten stronger resulting in a drag on net exports and thus a drag on aggregate demand. The strong dollar, however, has naturally kept a lid on inflation and inflationary expectations allowing the Fed to keep rates low. According to the real exchange rate of the dollar against a broad range of currencies, the dollar is as strong as it has been in over 15 years.

Summary

I believe the recovery is under way and we will experience ‘sluggish’ economic growth until at least the summer. The accounting fiasco will dissipate in a few months. I believe the key lies in the financial markets – i.e., the equity and credit markets. With regard to stocks, I believe we will go sideways for a few more months until the accounting scare subsides and demand picks up more robustly resulting in brighter profit outlooks. With regard to the credit markets, Greenspan has much experience in these matters and will provide the necessary liquidity to the banking sector in the case of a significant credit crunch. I see inflation being well behaved, the federal funds target remaining below 2% for much, if not throughout 2002. Economic growth will be positive with the final quarter of 2002 likely to exhibit the strongest rate of economic growth. Unemployment will probably rise above 6 percent and then begin falling by the end of the summer.