U. S. Economy Experiences "Soft Landing" in 1995; Look for More of the Same in 1996
J. Robert Gillette
In 1995 the United States economy moved well into its fifth year of economic expansion since the last recession ending March 1991 and experienced the much publicized "soft landing." The Federal Reserve (Fed) engineered this "soft landing" with a series of interest rate hikes from February 1994 to February 1995. The "soft landing" refers to the slowing down of an overheating economy on the verge of driving up inflation, to an economy growing near its full-employment growth rate with low inflation. The delicate balance of slowing the economy without also causing a recession (a "hard landing") appeared in jeopardy in the second quarter of 1995 when the economy stumbled, and many wondered whether the Fed had over-tightened monetary policy.
Along with explaining where the U. S. economy has been in 1995, and where it will likely be in 1996, I first review the 1994 economy. The booming 1994 economy, along with the Feds 1994 preemptive strike against inflation, set the stage for understanding the economy in 1995.
The U. S. economy in 1994 went gangbusters. Real gross domestic product (GDP), the value of all final goods and services produced in the U. S. adjusted for inflation, grew at an annual rate of 4.1 percent, which represents the highest growth rate of real GDP since 1984. As Figure 1 shows, real GDP grew at an annual rate of 3.3 percent in the first quarter, increased to 4.1 percent and 4.0 percent in the second and third quarters, and jumped to a whopping 5.1 percent in the fourth quarter.
FIGURE 1: Real Gross Domestic Product Rate
The unemployment rate, as Figure 2 shows, declined throughout the year, starting at 6.7 percent in January and declining to 5.4 percent in December. Non-farm payroll employment increased by an average of 294,000 per month, representing the highest percentage increase in payroll employment since 1988. Manufacturing jobs increased by an average of 30,000 per month.
FIGURE 2: United States Unemployment Rate
Inflation, as measured by the Consumer Price Index (CPI), dropped to only 2.6 percent, the lowest annual rate since 1986. Short-term and long-term interest rates increased throughout the year as the Federal Reserve tightened monetary policy and the booming economy raised the expectation of future inflation.
With the economy booming and at full employment, the Federal Reserve correctly became concerned about an increase in inflation. A booming economy is wonderful if it is sustainable, but a booming economy at full employment cannot be sustained and will eventually drive up inflation as the economy overheats.
To slow the economy to a sustainable growth rate and prevent higher inflation, the Feds policy-making arm, the Federal Open Market Committee (FOMC), raised interest rates eight times from February 1994 through February 1995. Specifically, the Fed raised the federal funds rate (the rate banks charge other banks for overnight loans) from three to six percent in a series of actions designed to prevent inflationary pressures from becoming embedded in the economy.
Slowing down a booming economy never makes the Fed popular. In 1994 the Fed took additional criticism because the much-feared inflation it was supposedly fighting did not appear in the 1994 monthly inflation numbers. Yet the Fed continued its tightening of monetary policyraising interest ratesanyway. With inflation generally static, why did the Fed keep fighting it?
The answer revolves around the fact that monetary policychanges in the money supply and interest ratesdoes not impact the economy quickly, but with a considerable lag. Tightening monetary policy has little impact on inflation for six to nine months, and does not have its full effect on reducing inflation for about 1½ to 2 years. Such extended lags force the Fed to prevent an increase in inflation by launching a preemptive attack on inflation. The inflation the Fed fought in 1994 was not the inflation for early-to-mid 1994. It was too late for the Fed to impact those inflation rates. In 1994, the Fed was fighting inflation for late 1994, 1995, and even 1996.
If the Fed waits for inflation to show up before it acts, it will be too late. As Fed Vice-Chairman Alan Blinder is fond of saying, the Bunker Hill strategywait until you see the whites of their eyes and then firedoes not work for monetary policy. If you wait to see the whites of their eyes, youre dead. If the whites of their eyes are showing inflation, youre about one year too late to prevent it.
1995 Economy: "Soft Landing"
The economy landed softly in 1995 with moderate growth and low inflation. The Fed successfully contained inflation and slowed the overheating economy without causing a recession. The soft landing appeared in jeopardy at the beginning of the second quarter when many economic indicators pointed down. Some observers feared a recession, wondering if the Federal Reserve had over-tightened monetary policy.
As Figure 1 shows, real GDP slowed during the first quarter to an annual rate of 2.7 percent, slowed further during the second quarter to 1.3 percent, but picked up during the third quarter to a surprisingly strong 4.2 percent. For the first three quarters, real GDP grew at an annual rate of 2.7 percent. If the economy hits the consensus forecast for the fourth quarter of 2.4 percent growth (discussed below), then real GDP will grow just over 2.6 percent.
Inflation through October, as measured by the Consumer Price Index, equaled an annual rate of 2.9 percent. Inflation accelerated in the first five months of 1995, running at an annual rate of 3.6 percent, but subsequently slowed down to a rate a little above the 2.6 percent rate of 1994.
The unemployment rate, as Figure 2 shows, hovered around 5.6 percent, averaging 5.7 percent during the second quarter weakness and dropping to 5.5 percent in October. Non-farm payroll employment increased at an average of 137,700 per month through October.
Industrial productionoutput of factories, mines, and utilitiesleveled off in 1995. As Figure 3 shows, the monthly index of industrial production rose considerably in 1994, at a 6.1 percent rate. In 1995, though, industrial production through October remained in the 121 to 122 range. In fact, the October industrial production index barely exceeded its January value. With this slowing pace, payroll employment in manufacturing through October decreased by an average of 16,500 jobs per month.
FIGURE 3: United States Industrial Production
Business inventories through April rose relative to sales. In the second quarter and even into the third quarter, businesses slowed production to expend excess inventories. With the start of the fourth quarter, inventories appeared to be back at appropriate levels.
The U. S. dollar went on a roller coaster ride in 1995, especially against the Japanese yen. The dollar started the year just above 100 yen per dollar. In February, however, the dollar plunged, hitting in late April a post-World War II low of 79.85 against the yen. The dollar remained low until August, then climbed to stand again at 100 yen per dollar. Against a broader index of nineteen currencies, the dollars plunge was not as severe, but neither has it fully regained all of its lost value against the broader currency index.
The dollars decline throughout most of 1995 stimulated U. S. exports, since the cost of the exports to other countries dropped. This boost was particularly helpful given the weakness in the economies of our major trading partnersCanada, Europe, Japan, and Mexico. As other economies slow down, they also curtail purchases of U. S. exports. Mexico, with its peso devaluation, suffered a severe recession, seeing its real GDP decline about seven percent.
Unlike 1994, the Federal Reserve was not as active in 1995. In the inflation fight, it raised interest rates for the last time on February 1, pushing up the federal funds rate by half a percentage point to six percent. With the economy slowing and the inflation outlook benign, in July the Fed cut the federal funds rate by a quarter percentage point to 5.75 percent.
If Congress and the President have passed a budget accord by the end of 1995, the Fed will almost certainly cut rates again in December by at least a quarter percentage point. The bond and stock markets have already factored into current bond and stock prices a significant deficit reduction package and a Fed rate cut, which have pushed up bond and stock prices and pushed down long-term interest rates. The budget accord, which would eliminate the federal budget deficit by 2002, will be somewhat of a short-term drag on the economy. Reductions in federal spending would likewise reduce the economys aggregate spending. To neutralize this drag, and to encourage deficit reduction, the Fed has indicated that it will cut interest rates if inflation remains benign.
Interest rates, especially long-term rates, dropped substantially in 1995. In 1994 these rates rose throughout the year, but favorable inflation, the prospect of significant deficit reduction, and Fed rate cuts generated significant decline in 1995. Rates leveled off, even rose somewhat, in the middle of the year, but declined again in late August. By mid-November, the long bondthe 30-year Treasury bondhit its lowest level since January 1994 when it yielded 6.22 percent.
At this time, the fourth quarter of 1995 is causing some nervousness. The consensus forecast centers around 2.4 percent growth in real GDP, but most analysts would be content with anything above 2.0 percent. In October, the first month of the fourth quarter, retail sales fell 0.2 percent and industrial production fell 0.3 percent. With relatively high consumer debt loads and weakened consumer spending, early indications are that a somewhat below average Christmas selling season will have resulted.
1996 Forecast: Look for More of the Same
In 1996, slow to moderate growth with low inflation should occur. The forecast for real GDP centers around 2.5 percent growth. The Blue Chip Economic Indicators Poll of fifty private-sector economists had a consensus forecast for real GDP growth in 1996 of 2.5 percent, with the highest ten forecasts averaging 3.1 percent and lowest ten averaging 1.9 percent. The Federal Reserve, in its 1995 semiannual report issued to Congress in July, forecast real GDP growth of 2.25 percent to 2.75 percent in 1996.
The inflation forecast centers right around three percent. The National Association of Business Economists forecast a 1996 inflation rate of 3.1 percent, and the Fed in its semiannual report forecast an inflation rate of 2.875 percent to 3.25 percent. Further, the Fed forecast an unemployment rate in 1996 of 5.75 percent to 6.125 percent.
With a benign inflation outlook, a sluggish economy in the fourth quarter of 1995, and the prospects of a federal budget accord, look for the Federal Reserve to lower interest rates at least twice, having begun in December 1995. Even though interest rates are currently low, the so-called real interest ratesinterest rates adjusted for inflationare above their historical average, making current monetary policy modestly tight.