Full text of Chicago Fed Letter : The Cost of Uncertainty, No. 43

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ESSAYS ON ISSUES

THE FEDERAL RESERVE BANK
OF CHICAGO

MARCH 1991
NUMBER 43

Chicago Fed Letter
1 ^ —

T he cost o f uncertainty
Based on economic fundamentals,
the current recession shouldn’t be
happening. The economy was
headed for, in fact had probably
achieved, the often-discussed but
never experienced soft landing envi­
sioned by policymakers and analysts
alike. Unfortunately, having landed
safely at the airport, the economy was
struck by a run-away oil truck while
taxiing to the gate. The damage
came not so much from the acci­
dent—it wasn’t that large a truck—
but from worries about whether
there were any more run-away trucks
lurking just out of sight.
Understanding what happened and
why is important if we are to learn
the right lessons from the recent

M^ ^ — 1

past. It would be easy but false to say
that the current recession shows once
again the futility of fine tuning the
economy through policy, and that the
only way to tame inflation is a good
old fashioned recession. In fact, care­
ful examination of the economic data
suggests that without the massive in­
crease in uncertainty that hit the econ­
omy in the wake of the Iraqi invasion
of Kuwait, inflation would have been
brought back under control without a
recession and economic growth would
have remained positive for the fore­
seeable future.
The soft landing

The assessment of the economy be­
fore the invasion hinges on two ques­
tions. Were we going to sidestep a
recession? and was inflation headed

back down? I believe the answer to
both of these questions is yes.
There is disagreement about what
would have occurred in the fourth
quarter of 1990 if there had been no
invasion, but a num ber of factors
point to continued growth. Up until
October the new NBER index of
leading indicators1and the related
recession forecasting equation fore­
casted only a 6 percent chance of a
recession. The reason for such a low
probability is that none of the nor­
mal danger signals were flashing.
Inventory-sales ratios in manufactur­
ing had been decreasing for over a
year, rather than increasing. Manu­
facturing employment also had been
falling for over a year and a half. As
Figure 1, panels a) and b) show, this
is highly atypical for the beginning of

1. Past and present cycles: portrait o f a soft landing
a) Inventory to sales ratio - manufacturers

b) Manufacturing employment

c) Fed funds rate

d) Coincident indicators

a recession. Also, as shown in Figure
1, panel c), interest rates have been
falling for over a year, normally indi­
cating an upsurge rather than a fur­
ther decline in output.
GNP from the third quarter of 1988
to the third quarter of 1990 averaged
1.5% growth, far below the 4.2%
average of the preceding 5 years. As
Figure 1, panel d) shows, the coinci­
dent indicator index had been flat for
over a year rather than rising to a
peak as it normally does prior to a
recession. The third quarter could be
called a cyclical peak only in the loos­
est sense of the word. It would be
characterised more accurately as the
end of a flat. This extended period of
slow growth experienced over the last
two years generated the adjustments
in inventories and employment,
noted earlier, that are typically associ­
ated with the later stages of a reces­
sion rather than its beginning.
In short, the real economy had expe­
rienced enough weakness to initiate
the recession adjustment process with­
out actually entering a recession.
Simply put, we had a soft landing.
On the price side we see much the
same story except delayed. Figure 2
shows that the inflationary pressures
that had built up in the production
process during 1988 and early 1989
beffan to ease off substancially in
1990.
Further, aggregate wage pressures
began to ease in the third quarter of
1990 and would likely have eased
further in the fourth quarter even
without the added impetus of the
recession. The reason for this belief
is that the aggregate wage numbers
were pushed up in the first half of
1990 not by higher wage gains but
because manufacturing wages were
not falling as fast as they had earlier
in the decade. Manufacturing wages
fell only 0.2% in the first half of 1990,
in comparison to the average annual
decline of 1% on a real basis from
1987 to 1989. No one would argue
that falling real wages are a source of
inflation. The real strength in wages
during the 80s, and the source of po­

tential wage-based inflation, was serv­
ice sector wage growth, which peaked
in 1989, as shown in Figure 3.
Complicating the inflation picture,
the CPI continued to show increased
price pressures in 1990, rising in the
first half of 1990 at a rate of 5.9%
(annualized). It had been 3.6% in
the last half of 1989. However, much
of this increase was due to a series of
special factors unlikely to repeat in
the future. For instance, a major
culprit in the observed acceleration
of inflation in the first half of 1990
was shelter costs, which, according to
the numbers, increased 2.9% be­
tween December 1989 and June
1990, causing the CPI to increase
0.8%, and accounting for 27% of the
total acceleration. Anyone active in
the housing market at the time
knows this is sheer nonsense. The

‘ Employment Cost Index.
S O U R C E : Bureau of Labor Statistics.

CPI’s use of the very thin rental mar­
kets to estimate overall housing costs
generated this statistical fluke. Com­
plicating the shelter picture were some
increases in temporary lodging costs
that seem to have been generated by a
shift in hotel chain pricing polices, as
casual travelers stayed home and the
hotel chains focused pricing on less
price-sensitive business travelers.
The other major special factors operat­
ing in the first quarter of 1990 were
the heavy discounting that occurred
during Christmas of 1989 and the
bankruptcies of several large retail
chains that caused apparel prices and
some related goods to jum p in price
after Christmas. Similarly, some large
scale consolidations in movie theater
chains boosted movie prices and gen­
erated a blip in entertainm ent prices.

Thus, while the CPI inflation numbers
coming into the fourth quarter of this
year were worrisome, in reality, infla­
tionary pressures—whether measured
by incoming producer prices or wage
pressures—had already peaked and
would likely have continued to im­
prove in 1991 and beyond, given the
weak growth trends.
To summarize, while recessions are
the abrupt corrections of excesses in
the economy, soft landings should be
characterized by the same correction
process except spread over a longer
time span. That is exactly what we
were experiencing until the Iraqi
invasion of Kuwait.
The invasion

The invasion caused consumers and
businesses to delay buying decisions
and speeded up layoffs and restruc­
turings. While the direct effect of the
increase in oil prices was negative, it
was not that large a change and by
itself would probably not have had
much effect on the economy. The
increase in uncertainty, however, was
enormous, especially as the crisis got
into full swing in October and No­
vember. Figure 4 shows the effect of
uncertainty on consumer purchasing
decisions and Figure 5 shows the TED
spread (the difference between Euro­
dollar and treasury bill returns), a
common measure of uncertainty in
the financial markets. As can be seen,
the change in uncertainty is dramatic
and occurred either in late September

‘ Percentage of consumers referring to "bad and uncertain times."
SO U R C E: University of Michigan Survey of Consumers.

or in early October. This was not a
slow building process of accumulated
unease growing out of the deep prob­
lems that the doomsayers dwell upon.
The problem uncertainty creates for
the economy as a whole is that when
faced with high levels of uncertainty,
individuals and businesses delay pur­
chasing decisions. While delaying a
purchase is inexpensive for an indi­
vidual, it can generate significant dis­
ruption in the economy as a whole if
everyone does it. Think, for example,
of the tremendous traffic jams caused
by looking at the accident on the
other side of the road.
Uncertainty primarily causes individu­
als to postpone purchases of durable
goods, such as cars, houses and re­
lated goods, until the situation re­
solves. Thus, despite low inventories
in manufacturing, large cut backs in
production instituted during the pre­
vious slow growth period, and declin­
ing mortgage rates, the uncertainty
generated by the Gulf crisis caused a
classic recession led by falling con­
sumer demand with the fall-off cen­
tered in durable goods. If this reces­
sion had been foreordained by the
weakness in real estate, the restructur­
ing of the service sector, or debt as
most of the analysts who were predict­
ing recession argued, the recession
would be centered in those sectors
instead of durable manufacturing and
retailing.
Nevertheless, the weakness in services
and real estate played an important
role in making consumers hypersensi­
tive to the problems that might arise
from the Gulf. Further, the economic
weakness resulting from the Iraqi
invasion of Kuwait significantly exacer­
bated the credit quality problems in
the financial system, further restrict­
ing the already tight flow of credit.
In reality this recession tells us very
little about economic behavior be­
yond the fact that external forces can
play a very large role in the economy.
It also reminds us that economic mod­
els—whether based on financial mar­
kets indicators or on economic funda­
mentals—cannot forecast rapid

6 0 -------------------------------------------------------------------------------------------------

______I I I I I I I I I I I 1 I I I I I I I I I 1 I I 1 I I I I 1 I___
7 /2 0 /9 0 8 /1 7

9 /1 4

10/12

1 1/9

1 2 /7

1/4/91

2/1

‘Eurodollar yield less T-bill yield.
S O U R C E: Wall Street Journal

changes in circumstance, nor should
they be expected to.
If the situation in the Gulf resolves
soon there is some reason to believe
that consumer and business confi­
dence will rebound and the economy
can return to its pre-invasion slow
growth path. However, the real eco­
nomic losses experienced during the
disruption may have lingering effects
on the financial system and on other
more fragile parts of the economy if
the situation fails to resolve quickly.
—Steven Strongin and
Francesca Eugeni
*The in d e x was d e v e lo p e d by Ja m e s Stock
a n d M ark W atson. See NBER Press
R elease, N o v e m b e r 1, 1990.

Karl A. S cheld, S en io r Vice P re sid e n t an d
D irecto r o f R esearch; David R. A llardice, Vice
P re sid e n t a n d A ssistant D irecto r o f R esearch;
C arolyn 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 ederal Reserve
B ank o f C hicago. T h e views ex p ressed are th e
a u th o r s ’ 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 be
re p rin te d if th e so u rce is c re d ite d a n d th e
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o f th e rep rin ts.
Chicago Fed Letter is available w ith o u t ch arg e
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C hicago, Illinois, 60690, (312) 322-5111.

ISSN 0895-0164

Manufacturing activity in the Midwest dropped sharply in November, follow­
ing a one month reprieve from a downward trend that began five months
earlier. The 2.2 percent decline in the MMI was the largest in several years
and matched the decline in manufacturing activity nationally. Both the MMI
and USMI reflected widespread weakness among industries. However, the
transportation sector was by far the hardest hit in the Midwest. Domestic auto
production nationwide was cut to a 5.3 million unit rate (annualized) in No­
vember, from a 6.8 million unit rate a month earlier. A further decline in
auto production in December to a 5.0 million unit rate foreshadows another
month of sizable declines in Midwest manufacturing activity ahead.

Chicago Fed Letter
F E D E R A L R E S E R V E B A N K O F C H IC A G O
P u b lic I n f o r m a tio n C e n te r
P .O . B o x 83 4
C h ic a g o , I llin o is
(3 1 2 ) 3 2 2 -5 1 1 1

60690

N O TE: 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
derived from ec o n o m e tric m o d els th a t
estim ate o u tp u t from m o n th ly h o u rs w orked
a n d kilow att h o u rs data. For 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 an u fac tu rin g In d e x e s,” Economic
Perspectives, F ederal Reserve B ank o f C hicago,
Vol. XIII, No. 4, Ju ly /A u g u s t 1989.