Economic Update

The economic expansion threatens to unravel. This is most evident from the increasingly dark conditions in the labor market. Corporate layoff announcements continue unabated, unemployment insurance claims are surging, and the jobless rate has risen to 4.5% from a nadir of 3.9% last fall.

Employment is falling. As measured by the payroll survey of businesses, the number of jobs has fallen for two months running. Save for months affected by bad weather, strikes and Census-taker layoffs, the last time this happened was in the early 1990s.

The key risk now facing the economy is whether the job losses and rising unemployment further cut into already fragile household incomes and confidence and induce consumers to reign in their spending more substantially. Retailing is already flat, and vehicle and homes sales, while strong, are at best just holding their own.

How consumers behave in the near future takes on added importance since businesses are significantly curtailing their investment. Real investment in information technology fell at a whopping 6%-plus annualized rate in the first quarter. Just a year ago, IT investment was booming at a greater than 30% pace. Total business investment has fallen for two consecutive quarters, the first quarter-to-quarter declines since the last recession.

The economy also is not receiving any succor from foreign consumers and businesses struggling with their own economic slumps. No global economy is experiencing stronger conditions, and growth is quickly decelerating among our big trading partners, including Canada and Japan. Real exports have been falling since last fall after being a source of significant growth throughout the previous year.

It is increasingly evident that the expansion will devolve into recession without further aggressive action by policymakers. The Federal Reserve Board has responded by lowering the federal funds rate target by 50 basis points on five occasions since the beginning of the year. At 4%, the Funds rate is the lowest it has been since the early l990s.

The Fed's actions may not be sufficient to forestall a downturn, however, and fiscal policymakers finally came through with some economic stimulus. A significant cut in personal income taxes with sizable tax rebate recently became law, and checks will be nailed to taxpayers beginning in ate July.

Recession indicators. To gauge whether the economy is devolving into recession, it is useful to monitor a handful of timely economic and financial indicators. While no one indicator provides an unambiguous message regarding the economy's condition, there are some very timely data that are particularly instructive.

A sensitive barometer of current economic performance is the number of unemployment insurance claims reported by the Bureau of Labor Statistics each Thursday morning. UI claims are an actual count of the number of people that have recently lost their jobs and are distressed enough to ask the government for financial help. Since it is a count and not based on a survey, it is not subject to the measurement biases that plague other economic data and render them less useful at economic turning points.

UI claims have risen strongly over the past year, from a nadir of close to 275,000 per week last spring to near 400,000 in recent weeks. The 400,000 mark is particularly important, since it was when UI claims breached that level a decade ago that the economy was firmly in the grips of recession.

The number of mortgage applications made each week to purchase a home and reported by the Mortgage Bankers Association each Wednesday morning provides insight into the near-term prospects for home sales and homebuilding. The housing market has remained remarkably resilient, with annualized new and existing home sales hitting a record high of close to 6.5 million units in March. That so many homes are being sold is the most compelling evidence that the economy has to date been able to avoid recession.

Since mortgage applications lead home sales by a month or two, and sales lead homebuilding by a month or two, any significant change in applications would signal an impending change in housing activity. The purchase mortgage application index has remained steadfast through early April, suggesting the housing market should hold up well and the economy will be recession-free through the spring.

Personal bankruptcy filings reported by credit card consortium Visa each week provide timely insight into the level of financial stress among households. Filings have been soaring since the beginning of the year, up some 20% in the first quarter compared to a year ago. Filers rushing to beat an expected change in the bankruptcy law that would make filing less financially attractive explains only part of the increase. As long as filings continue to accelerate, there is little chance that the economy is stabilizing.

Various financial indicators are also useful in gauging current and prospective economic conditions. These indicators not only are timely but, since they are determined in the marketplace, there are no survey or other measurement errors. Moreover, there are no statistical issues, such as seasonal adjustment, that often make nonfinancial data more difficult to interpret.

Given the influence that changing stock prices have on the economy's performance, it is instructive to monitor the Wilshire 5000. This is a comprehensive measure of price changes in the entire equity market, and roughly corresponds with the value of all publicly traded stocks. The Wilshire peaked just over a year ago at close to $15 trillion. It is currently trading at near $12 trillion. A sustained decline back below $11 trillion would signal that the economy is eroding further, while a rebound back over $13 trillion would suggest that the economy is reacceleraring.

The shape of the yield curve, as measured by the ratio of the yield on 10-year Treasury bonds and three-month Treasury bills on an equivalent bond basis, is also a very prescient economic indicator. Each time that the yield curve has inverted since the late 1960s, or three-month bill rates have risen above 10-year bond yields, a recession has ensued within a year. Moreover, during this period, the curve has never inverted and a recession not ensued. The yield curve is predictive since it embodies the collective wisdom of global fixed income investors who are anticipating the prospects for inflation and thus the economy.

The yield curve did invert last summer, suggesting that, if historical relationships hold, the economy will soon be in the middle of a downturn. The message in this inversion may be skewed, however, by the Treasury's efforts to pay down the national debt through buybacks of long-term Treasury bonds. Perhaps even more important, the curve is no longer inverted because of the Fed's aggressive monetary easing since the beginning of the year. If the economy does experience a recession in coming months, then the yield curve is suggesting that it will be relatively short-lived.

Outlook. The recession indicators are signaling that the economy remains out of recession--barely. If any of the indicators measurably erodes in the near term, then, in all likelihood, so will the economy.

Indeed, to avoid a full-blown recession, the economy will have to be the beneficiary of deft policymaking. Not only must the Federal Reserve Board remain aggressive in easing monetary policy, a tax cut will be needed as well. A tax rebate of $50 to $75 billion, with the Treasury sending out the checks this fall, would go a long way toward short-circuiting a downturn.

Even with a more stimulating monetary and fiscal policy, however, the economy will also need a fair amount of luck in coming weeks. There is a wide range of looming risks that must be avoided--including spiking gasoline prices, electricity disruptions, a major corporate bond or bank loan default, a financial or currency crisis in any of a large number of emerging markets, to name a just few.

Time for panic? No. Time for caution? Absolutely.

COPYRIGHT 2001 The Risk Management Association
COPYRIGHT 2005 Gale Group