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Reversal of Fortune
There is increasing evidence that massive economic stimulus is taking hold.


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David Malpass

Back in 2001, you couldn’t help but have a negative economic outlook based on the deflationary strength of the dollar and the super-tight fiscal and monetary policies that were then in place. But these situations have not only improved, they have reversed — and the economy may accelerate even faster than expectations. Growth, based on gross domestic product, could exceed 4 percent in the second-half of this year.

There is increasing evidence that massive economic stimulus — monetary, courtesy of the Federal Reserve, and fiscal, thanks to the president and supply-side minded lawmakers — is taking hold. The magnitude of the policy turnaround, which caps a constructive, multi-year reflation process, should overwhelm the economic negatives — including the drag from expensive oil and poor finances at the state- and local-government levels.

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When it comes to economic forecasting, much of the focus in recent months has been on the downside risks — and these are still a possibility. But it is more likely that the consensus is underestimating the strength of the rebound now that the dollar is back at a normal level. Economists, it seems, do not have much 20th Century experience with deflation and reflation, explaining the confusion over the outlook. (This confusion extends to the Fed.)

Expensive oil and its impact on other energy costs remains a concern. The high oil price raises questions about the effectiveness of the U.S. military campaign in Iraq and our domestic energy policy. Expensive oil diverts investment to high-cost places, like Siberia, from more growth-oriented endeavors. And it offsets about one-third of the demand-side effect of the latest Bush tax cut. But there’s still good reason to believe that oil prices will fall sharply once Iraqi oil ships and U.S. inventories build.

The Federal Reserve has continued to hype the risk of deflation, despite the current non-deflationary value of the dollar and the fact that there are no signs of deflation in market-based price indices. The resulting risk aversion in the U.S. and abroad has forced bond yields to very low levels, inviting increasing distortions in the economy. However, bond yields have not been good predictors of growth in the past, and they have not caused major disruptions when they correct to higher yields (for example, in late 1993). As U.S. growth accelerates, interest rates and bond yields will move higher, with less reliance on residential construction in the growth mix.

State and local finances are an increasing drag. However, the tax increases and spending cuts under consideration only partially offset the new federal tax cuts and spending increases. For example, some states are proposing income-tax rate increases of 1 percent for high-bracket taxpayers, offsetting about a third of the federal government’s 3.6 percent rate reduction to 35 percent from 38.6 percent. So it’s a partial, not a full, offset.

To be sure, the economic data has been improving. Job losses in May were less than expected while productivity growth has remained robust. Current employment indicators — 6.1 percent unemployment, 430,000 initial unemployment claims per week, 130 million total workers — are consistent with relatively rapid economic growth. Purchasing-managers indices for manufacturing and services have improved, and these are also consistent with relatively rapid economic growth. Retail sales growth has remained resilient.

Anecdotal evidence has improved, too: There’s been solid commercial loan growth at one of the nation’s largest banks. A red-hot value-fund manager is still finding lots of companies to buy due to earnings improvements. A mezzanine financier finds his whole portfolio suddenly beating targets. A restaurant chain saw its sales move from cold in April to warm in May to hot in June.

The stock market has been a big part of the optimistic story. In particular, it’s been very nice to see the Nasdaq handily outperforming in the recent rally. Nasdaq outperformance often points to faster economic growth. It also reflects how the recent tax cuts — on capital-gains, investor dividends, and the top marginal rate (along with accelerated equipment expensing) — benefits technology companies.

And now back to the Fed. The current level of U.S. monetary stimulus is massive. Real interest rates have fallen 5.2 percent from December 2000 to March 2003, reaching -1.2 percent. A swing of this magnitude may be historical. Gold prices, meanwhile, remain above $350, while commodity indicators are rising again after an Iraq-related pause.

The Fed’s monetary policy is being magnified around the world. The European Central Bank cut its interest rate to 2 percent despite inflation that is still running above target. This may encourage South Africa and Brazil to cut their rates. To slow their currency appreciation, many foreign central banks are cutting interest rates. Many, including the central banks of Japan and China, are also printing money to buy U.S. Treasuries. With the Fed describing itself as “accommodative,” the implication is that many foreign central banks are also increasingly accommodative.

Finally, the fiscal deficit has moved from a 2.6 percent surplus in 2000 to a 4 percent deficit. This fiscal-policy shift, roughly 6.6 percent of GDP, is the largest since World War II. Three growth-oriented tax cuts have been enacted in this period, with the most recent one coming much earlier and larger than most expected. By reducing the taxes on capital, labor, investment, and innovation, the tax-cut portion of the fiscal-policy shift should add substantially to growth and stock market share prices.

The outlook for the U.S. debt-to-GDP ratio has shifted from a contractionary de-leveraging (Alan Greenspan’s famous concern) to a stable outlook. Every way you look at this economy, there is more good news than bad.

— Mr. Malpass is the Chief Global Economist for Bear Stearns.



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