The US slowdown

inSight

08 Feb 2001

The US slowdown

The suddenness of the recent slowdown in the US economy has taken many by surprise. But policymakers have plenty of scope for turning this inevitable adjustment into a more sustainable growth path.

I am sure many economists who have been watching developments in the US economy have been surprised by the sharpness of the erosion in consumer and business confidence in the last few weeks. I suspect that these economists include those within the Federal Reserve. It is as short a time ago as 15 November that the FOMC meeting ended with an inflationary bias. We have seen, within only ten weeks from then, two cuts of 50 basis points each in the target for the federal funds rate.

The Federal Reserve press release on 31 January, giving the background to the decision taken by the FOMC on that day, made reference to consumer and business confidence having eroded further, but it offered no clear analysis of the factors leading to that erosion. It contained only a comment that the erosion was "exacerbated by rising energy costs" and that, "partly as a consequence, retail sales and business spending on capital equipment have weakened appreciably". It went on to say that "in response, manufacturing production has been cut back sharply" and that new technologies appeared "to have accelerated the response of production and demand to potential excesses in the stock of inventories and capital equipment".

This last comment seems to suggest a recognition by the Federal Reserve that there may have been excesses in the stock of inventories and capital equipment, although I do not quite understand the use of the word "potential" in that context. We have seen reports about US capital spending in IT in 2000 being more than that for the entire decade of the 1970s, and a growth rate well in excess of 20% in that year, after recording an annual average growth rate in the 1995-1999 period in the teens. The excess, at least viewed from afar, seems to be self-evident. So this may just be the beginning of the classical business cycle, driven by excess capital spending, which economists are familiar with.

In this connection, the Federal Reserve's notion that new technologies have accelerated the response of production and demand to such excess is interesting. I certainly hope that this is the case because, when the excess is in time absorbed, the necessary response on the upswing would also come at an accelerated pace, meaning that the unpleasant phase of the business cycle may be more short-lived than would otherwise be the case.

But it is not directly obvious why and how excesses in capital spending in IT are translated with such speed into the erosion, if not the breakdown, of consumer confidence of the dimensions registered in the latest figures. I cannot claim to possess any profound understanding of consumer behaviour in the US, but I tend to pay more attention, at least at the macro level, to the explanatory variables on income, savings, wealth and unemployment for insights. Other than the large downward adjustment seen in financial assets in the US in 2000, involving quite significant wealth destruction in the case of technology stocks, the behaviour of these explanatory variables has not provided much cause for concern. Where there was concern, as indeed reflected in the view of the Federal Reserve during the year, it was about the possibility of inflationary pressures building up. So it may be that the effect of wealth destruction has not been so small after all, notwithstanding the very substantial gains in the stock market and therefore wealth creation in the preceding years.

The savings rate in the US has traditionally been low and this makes consumers vulnerable if they are exposed to the stock market. The situation is worse if consumption is dependent upon asset price appreciation. This is particularly so at a time characterised by a technology revolution that financial markets have found difficult to price accurately and provide reliable price signals, resulting in huge volatility in financial assets. But there is a saving grace. The technology revolution has not run its course yet and the scope for further gains in productivity and economic growth is still very much there. And there is ample room in both fiscal policy and monetary policy in the US to take pre-emptive and corrective measures to make this inevitable adjustment to a more sustainable growth path a short process.

Joseph Yam
8 February 2001

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