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ESSAYS ON ISSUES THE FEDERAL RESERVE BANK OF CHICAGO FEBRUARY 1990 NUMBER 30 Chicago Fed Letter 1990 outlook: Slowdown, then pickup On December 13, 1989, twenty-six business economists from around the Midwest attended the third annual Economic Outlook Symposium, sponsored by the Federal Reserve Bank of Chicago. The participants submitted forecasts before the meet ing and gathered to discuss U.S. eco nomic growth in 1990. This Fed Letter reviews their key points. The fore casts do not necessarily represent the views of the Federal Reserve Bank of Chicago or the Federal Reserve Sys tem. They do, however, represent invaluable expertise on industries that are im portant to the Midwest. Much of the expected weakness in the economy is concentrated in the first half of the year. Expected growth in the first two quarters aver ages around 1.5%, but the pace ac celerates to roughly 2.5% over the last two quarters of the year. At the high end of the forecast range (that is, the upper quartile), GNP growth would be exceeding 3%, a very re forecast—but the weakness in indus trial production is substantially worse than in the rest of the economy. In fact, one third of the forecasts had at least two quarters of negative growth occurring between the fourth quar ter of 1989 and the second quarter of 1990. By the second half of the year, industrial production resumes the role of the engine of growth that it spectable pace under any circum stances. Underlying this pattern are the expectations that short-term interest rates will fall in 1990 and, by over half of the group, that long-term rates will fall as well. has been playing throughout much of the current expansion. This fore cast is a testimonial to the restructur ing of the U.S. economy, because it suggests that the industrial sector can have a downturn without pulling the entire economy into a recession. Consensus— a slower economy The consensus outlook, based on the median of 25 forecasts submitted, showed real gross national product (GNP) in 1990 growing at a 1.7% pace (see Figure 1). This means economic growth in 1990 will be roughly half as great as in 1989 and, in fact, the lowest it has been since the current expansion began in 1983. Moreover, the forecasts ranged from a low of 0.6% to a high of only 2.4%. Thus, even at its best, 1990’s growth is expected to be at least half a percentage point slower than the previous year’s. And at worst, two forecasts called for the economy to enter a recession (that is, two or more back-to-back quarters of negative growth). Although year-over-year expected growth in real GNP was below 2%— a level typically associated with “ nor m al” growth potential—the quar terly pattern of GNP growth cast a brighter light on the 1990 outlook. Industrial production also is ex pected to exhibit weakness in the first half and strength in the second half of 1990. Indeed, the manufac turing sector is a major source of the expected weakness of the economy. The median forecast of industrial production (which now makes up less than one third of the economy) showed a pattern similar to the GNP The consumer takes the driver’s seat If not from manufacturing, where is the strength in the economy ex pected to come from? Breaking down the GNP forecast into its major components, the consensus forecast indicates that the investment and export booms that propelled the economy in 1987 and 1988 had run their course by the end of 1989. The median forecast for investment spending in 1990 is 1.7%, just keep ing pace with the rest of the econ omy, compared to roughly 8% in 1988 and 4% in 1989. Similarly, net exports are expected to add about $5 billion to GNP in 1990, after adding $17-18 billion in the previous year. With inventory investment continu ing to decline and housing starts unchanged from their 1989 level of 1.4 million units, consumer spending emerges as the sole factor in keeping the expansion running. Thoughts of a consumer boom were quickly dispelled by the group, how ever; their median forecast was a mere 2.2% growth in personal con sumption expenditures in 1990— roughly half the pace set over the first half of the expansion. But, de spite fears of debt burden consumers curtailing their spending, the consen sus forecast has the consumer con tinuing to buy goods and services. One major exception: automobiles. ...but takes a pass on autos The auto industry ended 1989 with slumping sales and bulging invento ries. A rise in sticker prices and the curtailment of sales incentives earlier in the year, coupled with a slowing economy, reduced auto sales in the final quarter of 1989 to their lowest levels since the early 1980s. Interest ingly, by the end of the year imports were also struggling for sales, sug gesting that consumers were simply not in a mood to buy new cars. Pro duction has been adjusted, but these cutbacks were less dramatic than the sales slump. As a result, inventories of each of the “ Big T hree” domestic producers swelled to a 90-day-plus supply, compared to the preferred 60-day supply. A return to heavy sales incentives late in 1989 foreshad ows what the auto market is expected to be like in 1990. The median forecast for auto sales in 1990 was 9.9 million units, compared to 10.0 million in 1989 and 10.6 mil lion in 1988. That forecast is surpris ingly upbeat—sales around 10 mil lion units are generally considered a healthy year for the industry. And, indeed, sales are likely to be far bet ter than the 6-8 million unit volume associated with economic downturns. Yet, the forecast conceals the extent to which incentives will be required to generate that sales volume. Sev eral economists at the meeting ex pected domestic producers to be under tremendous pressure to lower prices (through incentives), in order to reduce their inventory overhang by springtime. In fact, one auto economist projected auto sales in 1990 to be as low as 9.4 million units. The weakness in auto markets did not appear to dampen Christmas sales at the end of 1989, however, and is not expected to spill over into other consumer goods markets in 1990. A point made by one retail economist was that the “middleaging” of the Baby Boomers, shifting markets toward a more family-ori ented population, would generate steady demand for both durable and nondurable goods throughout the 1990s. While retail sales growth would weaken between the last quar ter of 1989 and the first quarter of 1990, retail sales (excluding autos) should grow by 7-8% in current dol lars in 1990. Shipments of major appliances from the factory are ex pected to follow a similar pattern. Growth in appliance shipments is expected to decline 3-4% over the first half of the year and to rebound to only 1-2% over the second half. A bumpy landing for manufacturers Autos and appliances were not the only industries that were expected to be slowing over the first half of 1990. Among capital-goods producers, for example, an economist for an elec tronic-goods producer expects ship ments to slump to a 2-3% growth range in 1990, well below the double digit rates attainable under normal conditions. Office and computer equipm ent markets are particularly hard hit by weak cash flow expected in 1990. But sales of electronic equipm ent are expected to rebound to double-digit rates in 1991. Simi larly, a machine tool industry analyst anticipates a decline in shipments of roughly 10% in 1990, although new orders could be as much as 25% below 1989’s rate. Part of the weak ness in machine tool orders can be traced to the end of major invest m ent programs in the auto and aero space industries. But stiff foreign competition was also cited, despite recent declines in the dollar. Demand for steel is already feeling the impact of a slowing economy. Operating rates declined to 75% of capacity by the end of 1989 (com pared to an 85% average for the year). A key source of the softness in steel demand is reductions in new plant and equipm ent investment projects, which peaked in the second quarter of 1989, according to a steel economist. Auto plant shutdowns in January to control inventories will further soften steel demand. Steel shipments are expected to decline about 5% in 1990 to 80 million tons, still a respectable year. Among other producers of basic materials, operating rates are ex pected to be high, relative to con sumer- or capital-goods industries, but backing away from the flat-out, full-capacity operating rates of recent years. Growth in chemicals produc tion, driven by strong export de mand, product substitution, and an increase in demand for chemicallybased goods, continued to outpace overall industrial production in 1989. However, production of most types of chemical products in 1990 is ex pected to grow at less than half the 1989 pace (itself down from 1988). The paper industry, supplying prod ucts ranging from newsprint to pack aging, is coming off seven years of solid growth. Operating rates ex ceeded 100% in some segments of the industry as recently as 1988, but ended 1989 at about 93% of capacity. Shipments in tons are expected to grow only about 1% in 1989 and another 2% in 1990. Finally, the cement industry, which has been weak for several years, is expect to see continued declines in 1990. The industry has been affected by overbuilding in the commercial market in the early 1980s. Recent changes in the tax laws and a slow down in industrial building account for much of the expected decline in cement consumption in 1990. Despite a somewhat bumpy landing, the perception emerging from the meeting was that the manufacturing sector remains on the whole healthy and should finish 1990 in reasonably good shape. The bumps will be hardest in the first half of the year and much depends on how well the auto industry manages its invento ries. Operating rates will be more in line with long-run averages than with the peak levels of recent years. Profit margins will be narrowed. On the bright side— inflation eases What gave the widespread expecta tion of a soft landing credibility was the evidence of a slowdown in price increases. This slowdown is already appearing in price measures, such as the Producer Price Index for inter mediate goods (see Figure 2). The economists noted that: •Fear of inventory building will hold down effective prices (purchase prices, as opposed to list prices) among retailers at least in early 1990. •Automobile prices (based on con stant equipm ent and adjusted for incentives) declined in 1989, relative to the Personal Consumption Defla tor, and are expected to continue that decline in 1990. •Increases in appliance prices, intro duced early in 1989, have been wiped out by sales incentives. •Declining demand for steel has increased price competition, particu larly among service centers, and pro ducers are having difficulty in passing on labor cost increases. • Both the chemical and paper in dustries are experiencing a slowdown in demand as new capacity is coming on stream. This should keep down ward pressure on price increases for some time in the future. When asked to forecast the GNP implicit price deflator, however, the group of business economists re sponded with a median inflation rate of 3.9% in 1990, compared to 4.2% in the previous year. This improve m ent seems surprisingly modest for all the downward inflationary pres sures described at the meeting. Yet, it is im portant to rem ember that the manufacturing sector now generates less than 25% of the nation’s output and, thus, has a limited ability to influence aggregate measures of price movements. O ther areas of price pressure (such as health and educational services) are also impor tant sources of inflation and tend to be more insulated from the impact of short-term monetary policy than the manufacturing sector. Indeed, the modest improvement suggested by the median inflation forecast is in dicative of the dilemma facing mone tary policy—attacking producer price increases to bring down aggregate inflation requires such a severe slow ing of the economy that producers may not be able to make the neces sary investments that allow them to contain prices in the future. Aiming between the horns For now, it is fair to say that most business economists at the meeting believe progress is being made to ward reducing inflationary pressures in an orderly fashion. This should extend the current economic expan sion at least one more year. Far greater concern was expressed about the risk of recession in the months ahead than about a reacceleration of inflation. Extending the expansion by overstimulating the economy and raising inflationary pressures, how ever, is a risk that can not be ignored by any policymaker. If the business economists are correct in their fore casts for 1990, policymakers may feel that they have successfully passed between the horns of their dilemma. —Robert H. Schnorbus Karl A. S cheld, S en io r Vice P re sid en t a n d D irecto r o f R esearch; David R. A llardice, Vice P re sid e n t a n d Assistant D irecto r o f R esearch; E dw ard G. N ash, E ditor. Chicago Fed Letter is p u b lish ed m o n th ly by th e R esearch D e p a rtm e n t o f th e F ed eral Reserve B ank o f C hicago. T h e views ex p ressed are th e a u th o rs ’ a n d are n o t necessarily th o se o f th e F ederal Reserve B ank o f C hicago o r th e F ed eral Reserve System. A rticles m ay be re p rin te d if th e source is c re d ite d a n d th e R esearch D e p a rtm e n t is p ro v id ed w ith copies o f th e rep rin ts. Chicago Fed Letter is available w ith o u t ch arg e from th e Public In fo rm a tio n C e n te r, F ed eral Reserve B ank o f C hicago, P.O. Box 834, C hicago, Illinois, 60690, (312) 322-5111. ISSN 0895-0164 Manufacturing activity in the Midwest continued to edge upward in October, after a mid-year slump. The MMI rose 0.7% in October, marking the third monthly gain in a row. However, the index remains below levels attained in the first six months of the year. Food processing accounted for roughly half of the monthly gain. Machinery also showed improvement. The metalworking and transportion sectors, however, weakened. The auto industry has announced sizable production cutbacks, which could depress the region’s transportation sector over the remainder of the year. Manufacturing activity in the nation (measured on a comparable basis to the MMI) declined 0.6% in October, coming off its highest level of the year. The Boeing strike and San Francisco earthquake may have contributed to the decline. Chicago Fed Letter F E D E R A L R E S E R V E BA N K O F C H IC A G O P u b lic I n fo rm a tio n C en ter P .O . Box 834 C h ica g o , Illin o is 60690 (312)322-5111 N O T E: T h e MMI a n d th e USMI are co m p o site in d ex es o f 17 m a n u fa c tu rin g in d u stries a n d are deriv ed fro m e c o n o m e tric m odels th a t estim ate o u tp u t from m o n th ly h o u rs w o rk ed a n d kilow att h o u rs d ata. F or a discussion o f th e m eth o d o lo g y , see “R e co n sid erin g th e R egional M a n u fac tu rin g In d e x e s,” Economic Perspectives, F ed eral Reserve B ank o f C hicago, Vol. XIII, N o. 4, Ju ly /A u g u s t 1989.
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