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Economic Outlook
April 10, 2000 In my last Zell/Lurie Real Estate Center Newsletter, published November 27, 2000, I wrote, "If there can be one criticism of Greenspan's monetary policy over the past 13 years, it is that he has dragged his feet in lowering the Fed Funds rate in the face of declining economic activity . . . I found it regrettable that Greenspan did not concede the accumulating evidence of a slowdown by shifting to a 'neutral bias,' paving the way for lower interest rates." Unfortunately, events over the past 5 months indicate that my fear of inadequate Fed action was well founded. Despite lowering the Fed Funds rate by 150 basis points, the rate is still far too high considering the economy is on the brink of recession. Given that forward looking inflation is at most 2½ %, the funds rate should be at 4% and going down, not 5% and waiting for a mid-May Fed meeting. Can President Bush rescue the economy with a tax cut? No. Present tax legislation is too little too late. This year's tax relief is small and by the time the bigger cuts take effect, we will be coming out of the slowdown. Although I don't usually prefer to use fiscal policy to "fine tune" the economy, the current economic situation calls for a reduction of taxes. This is so since the government is running a surplus, thereby doing the saving that the consumer is not, and some of that government surplus should be transferred to the increasingly cautious household sector. One should recall that despite disappointment in the speed of relief provided by the Fed or Congress, this downturn will end whether or not it turns into a full-blown recession. Our country rebounded from slumps in the nineteenth and early twentieth centuries before there was a central bank and before there were federal income taxes to cut in order to stimulate spending. Market economies have a natural cycle of economic boom and contraction and although the Fed can "smooth the edges," it is unlikely it could prevent a recession caused by the sharp drop in Information Technology and telecom spending. In my opinion, whether the US economy actually enters into a recession or not depends squarely on the consumer. And the risk that consumer spending will slow markedly is substantial. The average household has been spending all of its income over the past two years, spurred by large gains in the equity market. But with those gains disappearing, consumers may have to do some "old-fashioned" saving in order to boost their retirement funds. Many households think they are saving, but they are not. Although they continue to contribute to their 401k and other retirement plans, they are at the same time offsetting that saving by sharply increasing the level of home equity loans. This transfer makes perfect sense, since the interest payments remain tax-deductible on housing-backed debt. As long as home prices are steady or rising, many consumers do not regard their spending of home equity proceeds as a form of "dissaving" that offsets their retirement contributions. Nonetheless, if households return to a saving rate of just 5%, which is still only one-half the average of the post war period, this will almost certainly throw our economy into a recession. With consumption two-thirds of GDP, and with the US economy just skimming above zero growth, a 5% reduction in consumption will move us into substantial negative economic growth. The equity markets have discounted a lot of bad news. But outside the tech and telecom sectors, the damage has been minimal. Therefore, it is not unreasonable to say that the non-tech sector has yet to come to grips with a full-fledged economic downturn, and further damage is a distinct possibility. But even if a recession does come, stocks are not apt to go much lower. This is because there are few alternative investments that offer satisfactory yields that are free from recession risks. Ten-year treasury rates are at 5% and even inflation-indexed bonds have dipped to 3½ %, fully one percentage below the peaks that they reached last year. There are higher yields available on lower quality debt issues, and I happen to think that a diversified portfolio of junk bonds is probably a good long-term buy. But clearly these returns are also subject to recession risk. It is the housing market where returns are still satisfactory and risk does not appear to be abnormally high. Clearly, investment in real estate doesn't have the long-term growth potential of equities and it was for this reason that real estate was shunned during the technology stock boom of last spring. But as far as yields go, real estate cash flows are looking quite attractive and these stocks have held up very well despite the slump that has hit other sectors of the equity market. As the certainty of rising long-term cash flows from equities becomes increasingly doubtful, I believe that real estate returns will hold up quite well as interest rates head downward.
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