2001 - 1967 REDUX?
Prepared by The Northern Trust Company
(January 5, 2001) Do you remember 1967? I certainly do, and fondly, too. After all, it was the year I took the lovely Catherine to be my lawfully wedded wife. But some of you might remember 1967 for another event -- the year of the mini-recession. After flying high in 1965 and 1966, the economy suddenly hit a downdraft early in 1967, much like the downdraft we have been experiencing in recent months. The similarities between now and then in terms of the Purchasing Managers' Index are shown in Chart 1 below.
Chart 1
The Fed started raising the funds rate late in 1965 as an overheated economy was beginning to push inflation higher. By the third quarter of 1966, the Fed had pushed the funds rate about 150 basis points higher than it had been a year earlier. Then, as economic activity appeared to be going into a tailspin in early 1967 (see Chart 1 above), the Fed reversed course and started cutting the funds rate. By the second quarter of 1967, the Fed had erased the 150 basis point funds rate hike it had only recently implemented. Sound familiar? Take a look at Chart 2.
Chart 2
What was my favorite leading indicator, the real M2 money supply, doing prior to the 1967 economic swoon? And what did it do after the Fed cut rates in 1967? Real M2 growth was sinking out in front of the sinking economy. As shown in Chart 3, year-over-year real M2 growth bottomed out in January 1967 at 1.2%. By the end of 1967, after the Fed had cut the funds rate by 150 basis points, real M2 growth had shot up to 6.5%. As of this past November, real M2 growth stood at 2.9%, considerably higher than its 1967 nadir of 1.2%. And December nominal M2 growth suggests that year-over-year real M2 growth may be on the rise. This comes before the Fed has cut rates. Assuming that the Fed will continue to lower the funds rate even after Wednesday's 50 basis point cut, real M2 growth could be expected to be growing considerably faster at the end of 2001 than it is now.
Chart 3
So what if real M2 growth picks up? I'll tell you what so. Go back and take a look at Chart 1. What happened to the Purchasing Managers' Index? It went from 42.8 in April 1967 to 58.0 in April 1968. Take a look at Chart 4 below, which shows the behavior of the CPI. With the economic slowdown in 1967, the year-over-year change in the CPI fell from 3.8% in November 1966 to a low of 2.4% in October 1967. But with the pickup in economic activity in the second half of 1967, with a lag, inflation also picked up, reaching 4-3/4% by October of 1968.
Chart 4
History may not repeat itself, but it does tend to rhyme. I think a good case can be made that 2001 is shaping up to be a lot like 1967. And if so, then 2002 could turn out a lot like 1968 - i.e., the economy overheating again, inflation rising again and the Fed raising rates again. Reinforcing my view of this is that I think fiscal policy is likely to get "looser" in 2002. Defense spending will probably be rising substantially without nondefense spending being pared. And I think the odds favor a more-than-insignificant cut in marginal tax rates, which, given the rate-pegging policy of the Fed, will be financed by Fed-created credit. The economy suffered only a mini-recession in 1967 thanks(?) to the quick rate-cutting action by the Fed. I suspect that the economy will experience, at worst, a mini-recession in 2001, again because of Fed rate cuts.
But if the Fed is successful in preventing a full-fledged recession in 2001, it will likely be just putting off the inevitable. As I wrote in the Thursday, January 4, daily commentary, I do not buy the Fed's statement that "inflation pressures are contained." The average hourly earnings data in the December employment report show that labor compensation growth is rising, not falling. In the fourth quarter, hourly earnings grew at an annual pace of 4.6%. This compares with 3.8% to 3.9% in the first three quarters of 2000. Fourth quarter productivity growth likely slowed further in the fourth quarter. Thus, unit labor cost growth in the fourth quarter should exceed the third quarter's 2.4%. With the expected slowdown in the production of high-tech goods in 2001, productivity growth will seem more "old era" this year than "new era," and so, too, will unit labor cost growth. If the Fed's more accommodative policy brings back 3% growth in the second half of this year, which I expect it will, then I think inflation will be rising at an uncomfortable rate early in 2002. My bet is 2002 is "checkmate" for Greenspan and the economy.
January 5, 2001 Paul L. Kasriel The Northern Trust Company 50 South LaSalle Street, Chicago, Illinois 312-630-6000