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March 1, 1990

Federal Reserve Bank of Cleveland

The Economic Outlook: Growth
Weakens, Inflation Unchanged
by John J. Erceg and
Paul J. Nickels

M. here was some sense of drama in
the air as the latest meeting of the Fourth
District Economists' Roundtable, held
January 26 at the Federal Reserve Bank
of Cleveland, came to order. With the
meeting set to begin at 9:30 a.m., many
of the 27 participating economists anxiously perused the fourth-quarter 1989
figures released by the Commerce Department just an hour earlier. Would the
numbers reflect the slowdown-without- •
recession so greatly anticipated as the
economy headed into its eighth year of
The answer was, largely, yes. The participating economists' median forecast
had called for a fourth-quarter real
GNP growth rate of 0.7 percent; the
government's advance estimate (subject, of course, to later revision) was
0.5 percent (see table 1). The government's GNP price index showed an increase of 3.8 percent for the quarter;
Roundtable economists had posted precisely the same median figure.
Naturally, their range of predictions
was wider. The high figure for fourthquarter GNP growth was 2 percent; the
low, a pessimistic -0.9 percent. The
range was equally broad for the inflation figure, with predictions spread between a high of 5.5 percent and a low
of 1.9 percent.

ISSN 0428-1276

Yet all gathered seemed to agree, despite the inevitable difference in views
on specifics among economists from
manufacturing, services, and banking,
that the economic expansion is still continuing, and several key factors seem to
suggest a strengthening pace later in
1990 and beyond.
• The Consensus Outlook
The median forecast of the economy
shows a growth rate in real GNP of
about 2.1 percent from the fourth quarter of 1989 to the fourth quarter of
1990, slightly less than the comparable
period in 1989. The forecasters anticipate growth at about a 1.5 percent annual rate in the first half, to be followed by about a 2.5 percent growth
rate in the second half, continuing into
early 1991. Only one economist expects a decline in real GNP in the first
half of 1990, with the decline to be followed by a 3.5 percent growth rate for
the second half of the year.
Where will the expected growth in the
economy come from in 1990? The forecasters agreed that fixed investment
and exports will provide most of the
strength, although growth rates in both
of those sectors are expected to be less
than in 1988 or 1989. A Midwest banking economist noted that business fixed
investment and exports, which accounted for 53 percent of the economic
growth between 1987 and 1989, were

The consensus forecast among economists attending the most recent
Fourth District Economists' Roundtable calls for continuing slow growth
well into 1990 followed by a more
rapid growth in output by late this
year. Little improvement is expected,
however, in the overall inflation rate
despite the current slow growth.

not expected to do as well in 1990. He
pointed to capital spending surveys for
1990 that call for a reduced pace of
spending from 1989; easing capacity
utilization rates in manufacturing; and
declines in cash flow brought about by
eroding profits as suggesting slower
growth in investment this year than last.
The merchandise trade deficit is unlikely to improve much in 1990 and
will hold in a $110 to $120 billion
range. That view is based on the rise in
the dollar exchange rate during the first
half of 1989 and an expected slowing
in economic growth abroad in 1990.
Most of the forecasters anticipate that
consumer spending will help to sustain
overall growth of the economy, but will
not add to the growth rate. An economist asserted that consumers have built
their desired stock of durable goods, at
least for the moment, and in the pro-


Change in levels, billions of dollars, s.a.a.r.a

GNP in constant (1982) dollars
Personal consumption expenditures
Nonresidential fixed investment
Residential construction
Change in business inventories
Net exports
Government purchases






GNP in current dollars
GNP implicit price deflator
GNP in constant (1982) dollars
FRB index of industrial production















Percent change at annual rates

Absolute levels, percent

Unemployment rate





a. Seasonally adjusted annual rate.
b. Calculated fourth quarter to fourth quarter.
SOURCES: Fourth District Economists' Roundtable, Federal Reserve Bank of Cleveland, January 26, 1990;
and U.S. Department of Commerce, Bureau of Economic Analysis.

cess have acquired considerable debt
relative to income. In 1990, he expects
that consumers will rely more on income growth than on debt acquisition,
and income growth will slow because
job growth has been slowing.
Given these real and potential pitfalls to
economic growth, what keeps the economy from sliding into a recession?
Among the mitigating factors offered
by some of the economists was the responsiveness on the part of the Federal
Reserve, which began to ease policy in
the spring of 1989; a corresponding
acceleration in M2 growth, beginning in
June 1989; the absence of major excesses in the economy that would have
to be corrected; and a relative stability in
the services sector of the economy.
"Consumer spending on services is four
times as large as spending on durables,
and will be the single most important
factor in 1990 for recession avoidance,"
concluded a banking economist.

• The View from Manufacturing
Concern for the short run was echoed in
comments of economists representing
various manufacturing industries. A representative of one of the Big Three automakers noted that combined car and
truck sales for 1989 were down 6 percent from 1988 levels and were off 9 percent from the record year of 1986. Sales
fell most significantly in the Northeast
(10 percent), which has been hit by recession in several of its key industries
and by declining real estate prices.
The auto economist noted that the Japanese share of the American market
has continued to grow. Each of the Japanese retailers had higher sales in 1989
compared to the previous year. An interesting aspect of this statistic, however, was the fact that 7.9 percent of
the current Japanese market share is in
the form of transplants — Japanese
autos manufactured in the U.S. — and
that virtually all of Japan's marketshare gain in 1989 came from this domestic source. "This is okay for the
U.S. economy, but bad for the domestic
auto industry," he noted.

The auto economist concluded his remarks by saying that the outlook for
1990 is not particularly bad, but that
profits will be squeezed and that excess
capacity will become a problem. He
laid any hopes for a significant recovery on the expectation that interest
rates will decline further by the end of
this quarter. Very likely, the first quarter will be the low point in sales and
production for the year.
A major manufacturer of appliances
echoed much of the automaker's concerns as they related to his own industry. Lower interest rates might be helpful, he said, while acknowledging that
lower interest rates over the past year
had not stimulated housing.
Concern for manufacturers of consumer durables centers on the softness
in the housing market. An aging population and a decline in new household
formations are hurting the purchase of
durables, such as major appliances, that
are usually associated with a strong
housing market.
The primary complaint emanating from
manufacturing is the tremendous pressure on profit margins. "Inflation is not
in commodities in the long run," noted
the economist. "It is elsewhere. Prices
are down in durable goods."
Another manufacturing economist concurred, noting that price increases in his
market segment are "nil." This economist predicted that capital spending will
rise in manufacturing because survival
depends on it, regardless of bad profits.
"Without spending to increase productivity, industries will die in the brutally
competitive 1990s," he said.
Aging capital stock will help to support
a strong capital spending year in 1990.
Growth in producers' capital equipment may nearly match 1989 levels,
and spending for industrial construction will remain strong into the mid1990s. All in all, growth in real nonresidential fixed investment may turn out
to match or exceed that of 1989, despite a mixture of developments within
that sector of the economy. It was

pointed out, for example, that the communications and electronics industries
will be weak in the first half of 1990
before reviving in the second half.
The manufacturing economist, reflecting a view among part of the group,
credited the Federal Reserve for having
made "preemptive" moves to ease
money in 1989, thus avoiding a large
decline in the economy.

The LEI, which includes three output
series, three series based on interest
rates, and one on exchange rates, is
used to predict the CEI six months
ahead. Because the CEI is closely correlated with GNP, the LEI can be used
to forecast the real GNP growth rate of
the next two quarters. Of the seven
leading indicators in the LEI, the researchers found that the most sensitive
and best predictor of real GNP is the
yield spread between the six-month
commercial paper rate and the sixmonth Treasury bill rate, because that
spread is affected by investors' expectation of risk of default on private debt,
which in turn will affect GNP growth.
The RI is an estimate of the probability
of a recession six months ahead. According to this index, the probability
that the economy will dip into recession by May 1990 is only 9 percent.
That probability is only 6 percent for
the month of June 1990, as reported by
the NBER several days after the
Roundtable meeting.

Percent change, annual rate









. I . I .

• Same Story, New Angle
The group's aggregate no-recession
forecast was lent further credence by
the latest research on business cycles,
and particularly on coincident and leading economic indicators. Two research
economists at the National Bureau of
Economic Research (NBER), one of
whom was a guest panelist at the Roundtable meeting, recently developed a pair
of new indexes that forecast growth and
turning points in economic activity.
Their experimental indexes include coincident economic indicators (CEI),
leading economic indicators (LEI), and
a recession index (RI).


1983- 1988








a. Actual data.
SOURCES: Fourth District Economists' Roundtable, Federal Reserve Bank of Cleveland, January 26, 1990;
and U.S. Department of Commerce, Bureau of Economic Analysis.

Looking backward, the RI successfully
predicted each of the four recessions
that occurred since the early 1960s, but
also predicted a recession in 1967 that
did not occur.
• Inflation: Any Progress?
About the most positive development
of the past year regarding inflation was
that the overall inflation rate, measured
by the GNP implicit price deflator
(IPD), did not worsen any further. Between 1988:IVQ and 1989:IVQ, the
IDP rose an estimated 3.9 percent, virtually the same as in the comparable period for 1988. In the first five years of
the current expansion, which began in
November 1982, the rate of increase
was about 3.1 percent annually.
The Roundtable economists expect that
little progress will be made in 1990 toward reducing the overall rate of inflation (see figure 1). They expect that the
IDP will increase again by about 3.9
percent for the year, measured fourth
quarter to fourth quarter. They expect
transitory improvement in the second
half of 1990, but see the inflation rate
accelerating to the 4 to 4Vz percent
range in early 1991. If that median forecast comes to pass, 1990 will mark the
third successive year of inflation near
the 4 percent range, even though economic growth has slowed considerably
since 1988.

There were some encouraging developments in prices during 1989 that reflect
changes in relative prices in the economy rather than changes in the aggregate price level. Producer prices for intermediate goods, excluding food and
energy, eased throughout 1989, and
crude materials prices, less energy,
have also been declining, although
price moderation at these early stages
of production has yet to be reflected at
the finished goods level. Spot prices
for raw industrial materials have fallen
about 10 percent since last spring.
Why do most of the forecasters expect
a persistence of 4 percent inflation in
1990 despite the several quarters of
softness in economic activity that they
project? Apparently, some believe that
a growth recession does not create
enough slack in the economy to allow
moderation in costs and prices. Moreover, some apparently believe that 4
percent inflation is generally acceptable to the public and to policymakers,
because of the perceived high costs of
transition to lower inflation.
Alternatively, however, some in the
group believe that the anti-inflation battle is being won, and that the overall
inflation rate will recede to the 3.5
percent range over the next several
quarters. They point to the weakening
in industrial prices, and to the fact that
wage increases for both manufacturing

and services workers peaked more than
a year ago.
Yet another inflation scenario calls for a
sustained inflation rate of about 4 percent this year and next, but a substantial
reduction in the rate by 1992. This scenario is based on the assumption that
the Federal Reserve is targeting a 2.5
percent growth rate for real GNP, despite a potential output growth rate that
is estimated at about 3.5 percent
What adds to the problem of inflation
is expectations about inflation, because
people act on their expectations. In a
study of three surveys of inflation expectations, a guest panelist pointed out
that even though all the surveys overestimated the inflation rate for the past
several years, the different groups in
those surveys have different views
about inflation, and each group acts on
its own inflation expectations. Households, for example, attempt to obtain
an inflation premium in their compensation, while financial officers attempt
to include an inflation premium in their
interest rates. Inflation expectations are
relatively sticky and cannot be altered
downward easily except by policy actions, according to the panelist.
The latest information shows some reduction in inflation expectations during
1989, although a combination of

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higher petroleum prices and rising interest rates abroad contributed to an increase in inflation expectations late last
year and early this year.
• Monetary Policy: To Ease or Not
to Ease
Many of the Roundtable economists apparently assume a close relationship between money stock and output, and expressed a belief that monetary policy
should loosen further to foster the
higher growth in output they anticipate
after mid-1990. They expect the prime
rate to fall to about 9.5 percent by midyear, followed by a small increase early
in 1991. Most of the economists assume a growth rate in money stock
(M2) in 1990 within a range of 5 to 7
percent, although only half would prefer growth that high. Expected growth
in that high range may also explain the
expected persistence of inflation in the
4 percent zone over the next several
Many others at the Roundtable, however, prefer money stock growth in a 3
to 5 percent range, which is similar to
the actual growth rates of the past three
years. In the view of a financial economist, this year is the appropriate time
to lower the monetary targets, despite
the high probability of a mild recession
he expects for this half. He considers a
lowering of the M2 target range for
1990 from 1989, combined with a state-

ment of support for achieving a gradual
reduction in inflation, as signals to markets of serious anti-inflation resolve
that would reduce inflation and expectations about inflation.
• Conclusion
Sluggish performance of the economy
that is widely expected between last
quarter and mid-1990 should be followed by a more rapid growth in output by late this year, according to
Roundtable economists. They also expect little improvement in the overall
inflation rate despite the three quarters
of slow economic growth that is anticipated. It is apparent that neither inflation nor expectations about inflation
have been significantly dampened as
yet by the present slow-growth episode. In suggesting further policy easing, some of the group apparently are
willing to risk the costs of higher inflation in the future.

John J. Erceg is an assistant vice president
and economi&and PaurJ. Nickels is an editor at the Federal Reserve Bank of Cleveland. The authors would like to thank Gerald
H. Anderson and Mark S. Sniderman for
helpful comments.
The views stated herein are those of the authors and not necessarily those of the Federal Resen'e Bank of Cleveland or of the
Board of Governors of the Federal Reserve

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