PeppercomBlog: The State of the Economy

Posted by Milos Sugovic

The IMF said back in April the U.S. was headed for a recession and will take the rest of the world with it. This month, it made sure to remind us of the elephant in the room since it finally got something right. On the other hand, the panel of economists that officially declare a recession, also known as the National Bureau of Economic Research (NBER), are waiting for the kiss of more data to wake up. But the pile of statistics we all are staring at is telling, nonetheless. We’re surely going down, and there’s no doubt the economic and financial fortunes have turned quickly.

Before jumping to conclusions, remember that the NBER defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

To make sense of the performance and behavior of the animal also known as the macroeconomy, let’s turn to ECON 102 for a second: Macroeconomics is about the aggregate, and indicators such as GDP, unemployment rates, and price indices facilitate the analysis of the whole. The whole is a sum of many legs, which all operate in tandem. Every action produces a reaction. So it’s important because it assists governments and corporations in the development and evaluation of economic policy and business strategy. Without further ado, here’s what we’ve seen thus far:

Real GDP measures the size of an economy adjusted for price changes and inflation. Its growth rate was positive in Q1 and Q2 of 2008, even though it experienced a slight drop in Q4 of 2007. In Q3, the US economy contracted at an annualized rate of 0.3 percent. This last hit on output was driven by a 3.1 percent drop in consumption, while government spending and net exports sustained the economy. Economists expect the US economy to shrink even further, possibly as much as 2.5 percent, in Q4 of 2008 when the full effect of the financial crisis will be felt.

Consumption is determined by disposable income – the amount of income left to an individual or household after taxes are deducted. Consumers choose to either spend this income, determined by the sentiment and propensity to consume, or to save it, that is, deposit it in a bank. The data show that in May consumer disposable income increased tremendously, probably due to the economic stimulus package. But it was severely negative in the following three months. So it’s no surprise that real consumption followed (dropped) while savings spiked. After all, consumer sentiment hit rock bottom and is still at levels far below preceding years. And this is alarming, given that consumption makes up about two-thirds of national output, or GDP.

Production or aggregate supply is a function of current and future (expected) prices, factors of production (labor and capital), and profits. The Producer Price Index shows a drop in August and September, and it’s no surprise that industrial production has dropped by over 2.5% - the largest negative growth rate in the last four years. Industrial production is often used as a proxy variable for investment in capital stock, which is a function of national income and interest rates. Given the expectations for the economy in both the short and long run, and the high costs of energy that squeezed profis, it’s no surprise that investment levels have dropped significantly.

Labor market trends point to high and growing levels of unemployment. Since late 2006, the unemployment rate has increased from 4.5 percent to over 6 percent, meaning that there’s excess supply of workers. In the same period, we’ve seen a drop in the job openings rate, that is, the demand for workers. With claims for unemployment benefits high, it will put downward pressure on wages, output, and the inflation rate as well.

Inflation hasn’t been much of a problem according to recent CPI data (despite aggressive monetary policy and the neutrality of money – see below). The simple explanation for this low growth rate in prices is the drop in both aggregate demand and aggregate supply. In fact, a contractionary economy doesn’t put much pressure on prices, and that has left some room for expansionary monetary policy aimed at stimulating growth. But deflation is now the main concern.

Monetary Policy exercised by the Fed can be characterized as aggressive, to say the least. The monetary base (money supply) has recently increased by 90 percent. That’s almost a doubling of the money supply which will increase liquidity and velocity of money. Problem is: it puts downward pressure on interest rates, which at this point has made real interest rates negative, meaning the U.S. is entering into a liquidity trap, as I’ve discussed in a previous blog entry. Granted, the decrease in interest rates, also shown by the decrease of the Federal Funds Rate to 1 percent, stimulates investment (as they’re inversely related) but it’s also inflationary due to neutrality of money.

Fiscal policy has been used to pull the economy out of a trough. Government consumption and investment at the federal, state, and local levels has been growing and increasing the budget deficit. But that’s a national issue with low priority at this point.

International trade is a tricky one despite the consistent weakening of the dollar. A drop in the value of the dollar vis-à-vis other currencies means exports are cheaper while imports are more expensive. On one hand, that’s good for producers facing foreign markets, but bad for an economy like the U.S. that relies heavily on importation and has a huge current account deficit. The data, however, shows a drop in both exports and imports of goods and services, and that has an ambiguous effect on the national economy, partially due to the J-curve effect.

Financial sector trouble deserves a blog entry of its own. It has been discussed ad nauseam, and I doubt that’ll stop soon. The main takeaway, however, is that every leading index of the stock market has exhibited a drop in value. Since stocks are a function of profits, and determine investment levels, it’s no surprise Wall Street has been volatile and crashing, and it’s spilling onto Main Street. But let’s see how, if at all, the bailout plan and indecisiveness on regulation will pan out.

To this day, it’s pretty clear a lot of tossing and turning has taken place. Some economists would label it as natural market corrections. Problem is: most “corrections” have been in the negative direction. A contractionary period is ahead of us, and there’s no turning back, so businesses must adjust operations accordingly.