TCS Daily


A Nightmare for Halloween

By Kevin Hassett - October 30, 2000 12:00 AM

The release of the latest Gross Domestic Product (GDP) figures last week highlighted how dangerous it can be when our policymakers rely on a failed model.

GDP, of course, is the best statistic we have on growth - it's the dollar value of all goods and services combined, and virtually everyone now agrees that the capital spending boom has provided big enough cost reductions to allow high growth without inflation.

Still, oblivious to the source of U.S. growth (capital spending rather than consumer spending), some at the Fed have been concerned that GDP has been growing too fast, and have been giving us rate hikes anyway. They're believers in the old-fashioned concept of the Philips Curve - the notion that low unemployment and high growth are always accompanied by high inflation. They aren't.

The effects of all six short-term interest rate hikes that the Fed has foisted on us since June of last year were apparent in last Friday's GDP release. GDP grew at a very modest 2.7 percent in the third quarter, down about two percentage points from the healthy pace of the last year.

Most striking was the steep decline in the growth rate of capital spending - that is, purchases of plant and equipment, much of it in high technology. Those purchases, in turn, make businesses more efficient, putting the brakes on inflation. In the first quarter of this year, capital spending advanced at an annual rate of 21 percent. In the second quarter, it advanced at an annual rate of 14.6 percent. We learned last Friday that capital spending increased only 6.9 percent in the third quarter, a steep drop-off (and it's one reason that tech stocks have been falling - since businesses aren't buying as much). GDP growth as a whole was still healthy for one simple reason. Consumers kept consuming.

This comes as no surprise to readers of academic literature. There is fairly strong evidence that investment in equipment responds significantly to swings in interest rates. Higher rates should depress investment. There is also little evidence that interest rates affect consumer spending.

But put it all together and a fairly scary image emerges. Rate hikes from the Fed have depressed investment but have not affected consumption much. Put differently, the rate hikes have suppressed supply but not demand. So, after all that pain, we have the same demand chasing fewer goods. The Fed rate increases have likely increased the risk that inflation will take off!

This brings to mind a vision of a nightmarish scenario. Inflation starts to take off in the coming months because of slower capital spending and steady consumer demand. The Fed sees higher inflation -- which is magnified by the oil shock -- and raises rates again. This depresses capital spending even more, and consumption just a little, so inflation accelerates. The spiral ends only when the Fed slams the economy into a deep recession.

This scenario is not very likely; the New Economy is stronger than that. But the strange thing is that the old-economy Fed watchers seemed quite happy with the GDP report, and the Dow advanced significantly in response to it. The observers felt this way because their model cares a lot about how much GDP growth we have, and very little about which things we are spending our money on.

New Economy types, however, know that the positive supply shock from higher equipment spending has been the source of our high growth and low inflation. To them, the latest release will be troubling. How troubling?

It is too early to panic, but I am certainly nervous. Investment numbers tend to jump around from quarter to quarter, and it would not be out of the ordinary for fourth quarter investment spending to surge back significantly. If it does that, then the New Economy will have proven more powerful than interest rate hikes. That could happen, but the one reliable measurement we have of fourth quarter activity is not looking good.

The Census Bureau's durable goods orders and shipments data, which give us monthly readings on the activity of our capital goods manufacturers is a superb indicator for what will happen next. Shipments count as output and go right into GDP. Orders, however, are far more important because they are a strong signal of future shipments. Last week we received the orders data for September, which will be highly correlated with the shipments in October. The news was not good. Orders for industrial equipment were down sharply in September, so the capital spending retrenchment may not be over.

Which leaves us, this Halloween, with some scary things to think about.
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