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ESSAYS O N ISSUES T H E FEDERAL RESERVE BANK O F C H IC A G O FEBRUARY 1992 N U M B ER 54 Chicago Fed Letter 1992 outlook: a question o f confidence Confidence is the bulwark of capitalism, as it is of democracy. —William O. Douglas A sense of caution framed consumer and business decisions during 1991, culminating in a year-end slump in confidence that helped to smother the recovery. In a cloudy forecasting envi ronment, thirty-eight economists and business analysts participated in the Federal Reserve Bank of Chicago’s fifth annual Economic Outlook Sym posium on December 11, 1991. This Chicago Fed Letter summarizes the dis cussions that took place at that meet ing and focuses on conditions in dura ble goods manufacturing industries important to the Midwest economy. Manufacturing activity helped lead the recovery that began early in 1991 but was also instrumental in the economy’s stalling towards the end of the year. Still, all the forecasts prepared for the symposium expected the economy to avoid declining from 1991 to 1992, with housing starts, car sales, and in vestment spending each expected to record gains. If so, manufacturing activity linked to spending in these sectors should post improved results in the new year. 1991: what happened to the recovery? The consensus forecast produced a year ago was prepared in an uncertain atmosphere, with escalating oil prices and consumer confidence shaken by the war in the Persian Gulf. In light of the heightened level of uncertainty, that forecast performed relatively well in describing the economy’s perfor mance in 1991. The economy began to turn upward toward the end of the first half of the year, albeit somewhat slower and later than the consensus forecast had anticipated. But the recov ery’s momentum began to unravel in the fourth quarter—a period when last year’s forecast predicted continued improvement in growth. It is now evi dent that real GNP (in 1982 dollars) declined slighdy in 1991, in contrast to last year’s forecast of an increase of 0.4%. Why did the recovery stall? the downturn. Unfortunately, as the year progressed, a sense of caution remained pervasive and prompted the postponement of many consumption and investment decisions. Before com mitting their present and future re sources, consumers and investors wait ed for solid evidence of a strong recov ery. In turn, when consumers and investors delayed their spending, a strong recovery did not occur. Job creation over the second and third quarters was anemic by historical re covery standards, reflecting in part the Trends in consumer and business confi dence lie near the heart of the prob lem. A business condi tions research firm called the Conference Board conducts a monthly household survey and publishes a diffusion index that measures consumer confidence. The over all index has two major components: apprais als of current condi tions, and expectations for conditions six months into the fu ture. When the war in the Persian Gulf end 1990 1991 ed, the overall index SOURCE: The Conference Board. rose dramatically. lack of a commitment to the future on Interestingly, the improvement was the part of many businesses. In turn, concentrated in expectations, while appraisals of current conditions contin consumers’ appraisals of the recovery remained reserved, as employed peo ued to sink (see Figure 1). ple focused on friends and family members who had lost their jobs. Beginning in the second quarter of 1991, the complex network of manufac Concern with structural problems in the economy, such as the effects of turers, wholesalers, retailers, and other federal, state, and local government businesses supporting the production fiscal stress, also impacted confidence and distribution of consumer durable goods joined consumers in anticipating and spending. a turnaround. Gains in production By late 1991, the failure of consump and distribution activity helped stem tion spending to meet producers’ the slide in employment and boosted expectations put a damper on manu personal income in several durable facturing activity. Inventory building goods sectors that had suffered during by durable goods retailers in the third quarter was followed by softening in the production of durable consumer goods in the fourth, which could indi cate that much of the inventory build ing was involuntary. Weakening was particularly evident in the production of autos. Car assembly schedules were pared considerably during the final quarter of the year. In early August, planned assemblies for the second half of 1991 were just 0.5% below the same period in 1990, but actual production in the second half was nearly 7% be low year-earlier levels. The slow improvement in the overall labor market came to a halt late in the year. In November, most of the recovery’s employment gains were erased by a 241,000 decline in payrolls. As the economy failed to improve to meet expectations formed earlier in 1991, confidence slumped again in the fourth quarter, with new deteriora tion in expectations joining the con tinuing decline in appraisals of current conditions. The consensus outlook for 1992 In the face of a weakening recovery, the median forecast produced at the December 1991 symposium still called for modest but improving real GNP growth throughout 1992 (see Figure 2). Some economic reports issued in the weeks after the forecasts were prepared were unexpectedly weak, however. This led several economists to attach notes of caution to their forecasts during their presentations. The forecasts were prepared just be fore the comprehensive revision to national income accounting, adding some additional uncertainty to the forecasting atmosphere. Based on GNP in 1982 dollars, the growth esti mates should not be viewed as precise forecasts, but as rough indicators of future patterns.1 The estimates for real GNP growth in 1992 fell in a range of slow but positive growth rates (from 1.3% to 3.3%), with personal consumption expendi tures, residential investment, and in ventory accumulation each expected to provide positive contributions to “The consumer’s ability to spend looks weak,” this speaker 1991 1992 stated, “while his ( Y e a r - to - y e a r % c h a n g e ) willingness to spend looks terrible.” Au Real GNP (1982 dollars) -0 .5 2.1 tomotive sales have Personal co n su m p tio n also faced structural expenditures 0.3 2.2 obstacles, particularly 3.0 Business fixed investm en t -2 .8 as the industry un 8.6 Residential in vestm en t -11.6 winds the effects of the extension of car G ove rn m en t spending -0 .5 -1 .6 loan maturities in the mid-to-late 1980s. In addition, domestic automakers’ growth throughout the year. Consum quality improvements helped lead to er spending growth was expected to longer car holding periods, contribut be modest but consistent. Forecasts of ing to near term sales weakness. Still, business fixed investment and residen this analyst expected an upturn by the tial investment were more widely dis second half of 1992, citing the positive tributed than those for consumer effects of lower interest rates on na spending, but nearly all of the fore tional income. The symposium’s me casts called for positive growth in dian forecast called for car sales to rise 1992. The median growth forecasted from an estimated 8.4 million units in for these two forms of investment 1991 to 9.1 million units in 1992, but spending was the highest of the major this pace is still lower than the 9.5 GNP components, and the median million units sold in 1990. forecast for business fixed investment called for growth to increase as the year progressed. Production at machining shops is closely linked to demand for autos and other consumer durable goods. Activi What industries might ty in this metal processing industry benefit in 1992? generally continued to soften over the Despite the continuing slump in con latter half of 1991, according to an sumer and business confidence, sever industry survey presented at the sym al sectors that are sensitive to changes posium, although production levels in sentiment were forecast to provide still remain above those in the early sources of strength this year, including 1980s. A national association of ma autos, housing, and business fixed chining firms has forecast a significant investment. Importantly, spending in improvement in sales to the motor these areas is also sensitive to changes vehicle industry next year, while gains in interest rates. Not one forecaster in housing starts were expected to expected higher long term interest translate into higher orders from man rates in 1992. ufacturers of household appliances. Housing starts were expected to im In spite of all the bad news coming prove by every forecaster at the sympo from the auto industry, new car sales sium, with growth estimates ranging were still expected to rise in 1992, from 9% to 30%. If these expectations providing perhaps the most important are realized, Midwest machining shops contribution to the predicted recov linked to appliance and furniture ery. One motor vehicle industry ana production could join auto suppliers lyst noted that the consumer has been in recovering after a difficult year. exposed to a series of bad news stories: little change in employment in the last The machine tool was described by a six months, numerous announce manufacturer’s association representa ments of layoffs by Fortune 500 com tive as “the mother tool, the only ma panies, rising taxes at state and local chine that can replicate itself.” Sales of levels, and little improvement in real this product have long been viewed as disposable income per household. a key indicator of trends in investment 2* Symposium s median forecasts spending. Orders received by domes tic builders of machine tools held up relatively well through the end of 1990. However, as 1991 progressed, low production levels at machining shops and underutilized capacity at more integrated manufacturing firms triggered cutbacks in orders to manu facturers of “the mother tool.” Through October 1991, shipments were 20% below the same period in 1990. It should be noted, however, that several industry participants per formed relatively well during the year, with one noting that machine tool purchases have become linked more closely to productivity improvement than to capacity considerations, a de velopment which has helped to mute cyclical swings in spending. A consen sus forecast of industry analysts pre sented at the December meeting called for net new orders received by domestic manufacturers to increase nearly 20% in 1992. Export business provided a bright spot for U.S. ma chine tool manufacturers during 1991, and the industry may benefit this year from the late December 1991 extension of import quotas. Expan sion of durable goods production capacity in Mexico was cited as one key source of future strength, as that coun try does not have a significant machine tool industry. Low levels of capacity utilization have constrained capital goods investment in another industry important to Mid west manufacturing activity. A pro ducer of medium- and heavy-duty trucks noted that many motor carriers continue to operate with fewer trucks than they own or are able to lease, holding down orders for new trucks and truck engines. Motor carrier freight levels rose with the anticipatory surge in industrial activity that took place in the middle of 1991, but not sufficiently to warrant additions to fleet capacity. Sales of both mediumand heavy-duty trucks fell roughly 20% (in units) in 1991, and remained well below replacement volume. Gov ernm ent purchases account for as much as one-quarter of medium-duty vehicle sales, and state and local fiscal conditions have adversely affected sales of school buses. In the third quarter of 1991, shipments of new school buses fell to their lowest level in three decades. Orders of mediumduty trucks have shown signs of level ling out recently. One manufacturer anticipated that sales would increase roughly 4% (in units) in 1992, with most of the growth coming in the latter half of the year. Heavy-duty truck sales were expected to improve at a slighdy faster pace than sales of medium-duty vehicles. Domestic production of most types of capital equipment softened in the final quarter of 1991, but significant im provement in investment spending is still planned for 1992, according to the most recent quarterly survey of invest ment intentions by the Commerce Department (conducted early in the fourth quarter of 1991). In the survey, real spending for 1991 was projected to decline 1.1%, after an increase of 3.3% in 1990. The anticipated decline for 1991 is small compared to the sharp 4.1% drop registered in 1986, however, and plans for 1992 called for a gain of nearly 6%. Above-average growth in investment was planned by producers of motor vehicles and elec trical machinery, although two other important industries in the Midwest that face overcapacity—primary metals and paper—anticipated relatively sharp declines in investment spending. The demand for construction equip ment was influenced by developments in the commercial real estate market during 1991, and the outlook for 1992 appears little changed for equipment manufacturers. Retail sales of con struction equipment languished last year, leading to sharp cutbacks in production among Midwest manufac turers. In several cases, the soft mar ket prompted equipment manufactur ers to reduce production capacity permanently. In addition to the over supply of buildings, a speaker noted that the outlook for nonresidential construction activity has also been weakened by the fiscal status of state and local governments. This forecast er expected housing starts to continue to recover slowly this year, which could help to support the demand for some types of construction equipment. The recent federal legislation providing new taxpayer funding for transporta tion construction is also expected to provide some support for the industry. On the agricultural equipment side of the off-highway vehicle sector, sales generally held up better than construc tion equipment through most of 1991, although unit sales of combines soft ened considerably towards the end of the year. Farm income growth re mained sluggish during 1991, as the gradual reduction in subsidies com bined with softening prices to curb farm revenues. In 1992, one forecast er expected higher acreage plantings and stable land values to lend some support to equipment demand, but retail sales of tractors and combines were still anticipated to show small declines from 1991 levels. Durable goods spending inevitably translates into demand for steel and other basic materials. A steel industry forecaster expected domestic steel shipments of 78.5 million tons in 1991, and 82 million tons in 1992. The year-over-year gain does not suggest strong improvement, however, as the 1992 pace is flat compared to the sec ond half of 1991. This forecaster not ed that trends in steel are a good indi cator to watch when gauging the strength of investment, in part because basic materials procurement leads total investment spending. This pro ducer noted a steady increase in or ders and shipments as 1991 progressed after a particularly difficult first quar ter, and domestic steel production i Karl A. Scheld, S en io r Vice P re sid en t an d D irecto r o f R esearch; David R. A llardice, Vice P re sid en t a n d A ssistant D irecto r o f R esearch; Carolyn M cM ullen, 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 ederal Reserve System. A rticles m ay b e re p rin te d if th e source is c re d ite d an d th e R esearch D e p a rtm e n t is p rovided with 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 atio n C e n te r, F ederal Reserve B ank o f C hicago, P.O . Box 834, C hicago, Illinois, 60690, (312) 322-5111. ISSN 0895-0164 marked for business investment included food processing and chemicals. Still, this analyst presented his forecast with a high degree of caution. Lower interest rates and the oudook for recovery J F M A M J J S O U R C E : American Iron and Steel Institute. A S showed gradual improvement (see Figure 3). The upturn came first in demand for light products designed for autos and appliances. Orders for heavy products such as electrical ma chinery, which are more closely tied to investment spending, turned upward later in the year. Demand for steel used in heavy products was expected to stand a better chance of improve ment in 1992 than demand for light products, as the outlook for consumer spending remained restrained and the prospect for investment spending by corporate customers was enhanced by financing activity late in 1991. Indus tries expected to contribute to relative strength in sales of products ear O If the future unfolds as the forecasts ex pect, industrial activity linked to housing, the N D auto industry, and durable goods spend ing could again help lead the national and Midwest economies onto a path of moderate, sustainable growth. Predict ing the future of an economy sensitive to shifts in confidence is a difficult task, however. Indeed, the weakening in the recovery in the fourth quarter of 1991 was unexpected by most present at the symposium, and could also indi cate that structural obstacles to growth are stronger than previously thought. Developments since the December symposium suggest that the forecasted levels of growth could be over-optimis tic, but the pattern of growth (with most of the gains concentrated in the latter half of 1992) currently appears to be the most likely outcome. Since the December 1991 meeting, interest rates have continued to de cline. For instance, the discount rate dropped to 3.5% on December 20, reaching its lowest level in 27 years. It is also noteworthy that no forecaster at the December meeting predicted that long term interest rates would be higher in 1992 than in 1991. Lower interest rates should have at least two stimulative effects: they reduce the cost of goods purchased on credit, and they can relieve consumer and business debt burdens through refi nancing activity. Lower rates should also provide an important indirect benefit: by reducing the cost of acquir ing and holding assets that require financing over an uncertain future, lower rates can help support economic activity in the presence of weakened confidence, and prompt the initial risk-taking required to help rebuild more generalized confidence in future economic growth. —William J. Bergman and Robert H. Schnorbus1 1A m o n g th e revisions, G ross D om estic P ro d u c t re p la c e d GNP, a n d th e base year fo r p rices was u p d a te d to 1987. F o r a b rie f overview, see R o b e rt P. P ark er, “A preview o f th e co m p reh en siv e revision o f th e N atio n al In co m e a n d P ro d u c t A ccounts,” Survey o f Current Business, O c to b e r 1991, pp. 20-28. IIIS -S S g (2 lS ) 06909 sJo u H II K8 x°9 Od I3 U I3 3 u o p r u u o ju i D ljq n d O O V O IH O 3 0 3 N V 9 3 A ^ 3 S T H 3 V H 3 C I3 3 aottoq paq oSuoiq^
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