TCS Daily


Economy Enters The Twilight Zone; Is It In Recession, Too?

By Kevin Hassett - February 12, 2001 12:00 AM

One of the joys of exploring must certainly be the thrill of turning a corner and seeing a world filled with unfamiliar and exotic flora and fauna. Lately, as I have been watching economic developments, I have started to get the feeling that I am looking at a wholly different and strange economy, as if I have landed on an island where fish climb trees, birds ride horses, and dogs graciously share food with one another. It is all so weird.

Rod Serling couldn't possible have plotted a more mind boggling sequence of economic events, and, as was so often the case in the old Twilight Zone episodes, characters are beginning to turn up who seem convinced that a black hole (in the form of a recession) is about to swallow us all.

I submit the following facts for your consideration:

1. The U.S. economy added about 268,000 jobs in January. Even after accounting for weather-related seasonal oddities in the construction industry, the job gains were very healthy.

2. The productivity of U.S. workers increased at a robust 2.4 percent rate in the fourth quarter of last year, even while economic growth appeared to be slowing. Apparently, firms are still squeezing significant productivity gains out of the IT revolution.

3. Consumer confidence has fallen out of bed. Interestingly, consumers continue to say that things are fine currently, but that they anticipate that future conditions will be much worse.

4. The Federal Reserve has now cut interest rates by a full percentage point in less than a month. Futures markets put about a 75 percent chance on another half point reduction by April, and consider a further 25 basis point reduction a sure thing by the summer.

5. Chain store sales soared almost 5 percent in January, indicating that consumers reopened their wallets after a cautious holiday season.

6. The manufacturing sector is clearly in the tank. Purchasing managers are gloomier than they have been since the deep recession of the early 1980s. The president's economic staff left a meeting with CEO's with the shivers. The stories of disappearing demand were horrifying.

It goes on and on. One thing looks awful and another thing looks fine.

What a challenging time to live "in the data." Five years from now, with the benefit of hindsight, analysts will have all the answers. If we have a recession, they will point to the "old-reliable" Purchasing Managers Survey. If we escape recession, it will have been obvious to anyone who relies upon the employment reports. But here, in the data, the answers are not nearly as obvious.

Amid such chaos, the best place to start is often with a question. What is the most important question right now? My leading candidate is: "Did the stock market boom feed capital investments in projects that have negative present values?" Another way of putting that is: "Did firms buy junk with their capital, so that they have lots of machines that they will have to retire?" To my mind, that is the key question right now.

If firms did over invest, then their best choice is to throw the throttle into neutral and wait until their current overcapacity better matches demand. Their worse choice is to start closing plants and taking big write-offs. They will have to take these steps, which would clearly be a strong impetus casting us into recession, if corporate profits turn into losses.

How do profits look? There is no macro data to look at, but adding up profits for the S&P 500 from the earnings reports for the fourth quarter of 2000, it looks like profits year-over-year will decline a few percentage points. Since profits were very strong through the third quarter, they must have dropped off the table in the fourth, with many firms taking losses. That is pretty bad news, suggesting that restructuring may be about to be big.

Before I looked at profits, I was fairly sure that a recession was unlikely. Now I am less sure. Looking ahead, the Fed's rate cuts will provide a big boost to profits in the first quarter of this year. Will it be enough? I'll keep my computer running, and TCS readers will be the first to know.

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