If They Had Only Known

August 19, 2002

Every July, the Bureau of Economic Analysis (BEA) releases revisions to the previous three years of economic data. Economists generally dread the revisions, as they are almost always large, and often alter their view of history significantly.

This year was no different. The revisions have put to rest the debate over whether we had a recession--we did. However, it started and ended sooner than originally thought, and remains the mildest in history. Moreover, the recession showed signs of ending well ahead of September 11.

This report takes a closer look at how the revisions changed our view of history, and what effect, if any, they have on the outlook. The box to the right also highlights the dangers of such extraordinary revisions. There is little doubt that policymakers would have behaved differently had they known the path the economy was taking before the recession.

Revisionist History

Once again, the Bureau of Economic Analysis (BEA) has found itself with egg on its face. Not only did the economic downturn occur sooner and end earlier than previously recorded, but the economy was also much weaker leading up to the recession than initially thought. According to the new data, the recession started in the first quarter of last year and ended in the third quarter. (See Chart 1.)

*--Seasonally adjusted annual rate.

Moreover, the rebound after September 11 is now more substantial than previously thought. The fourth quarter of 2001 was the strongest in a year and a half, and a full percent stronger than initially reported.

This means that the National Bureau of Economic Research--the group that "officially" calls turning points in the cycle--declared the recession after it was already over. Indeed, the third quarter would have posted a reasonable gain absent the disruptions created by the terrorist attacks. (There is ample evidence that the economy was on the mend well ahead of September 11.)

More importantly, policymakers may have had more time to act preemptively against the recession had they known the actual growth path of the economy prior to the recession. Both the Fed and Congress would have viewed the need and timing of stimulus very differently if they had seen the revised 0.6% growth of the third quarter of 2000 instead of the almost 2% growth rate initially posted.

Indeed, the Fed s attempts to hedge itself against recession, which started with its historic inter-meeting move on January 3 of last year, now look to be more coincidental than pre-emptive. (i.e., the Fed was given information that led it to believe it was hedging the downside risk of recession, when it was actually fighting a recession already in progress.)

Separately, productivity growth dropped during the recession, which is more consistent with the new data. However, this Shouldn't undermine confidence in the powerful bounce-back in productivity growth seen after the events of September 11. The push by businesses to increase productivity over payrolls not only continues, but appears to have intensified. Revisions to productivity growth show that businesses were even more intent on raising productivity and defending the bottom line in the fourth and first quarters. More importantly, year-over-year gains are still running at the highest levels since 1975. (See Chart 2.)

Finally, on a more positive note, the consumer remained a pillar of strength, which is one of the most unique characteristics of the downturn. >From the perspective of Main Street, it remains more of a "recessionette" than the recession felt on Wall Street.

The Move Into 2002

The data for 2002 were also revised down. The composition of growth in the second quarter, however, came in very close to what we were expecting:

  • Consumer spending slowed but did not collapse;
  • Equipment spending posted its first gain in over a year, with growth in information equipment far outpacing expectations;
  • Inventories started their move into positive territory, but remain extremely tight across most industries; and,
  • The trade deficit deteriorated. Indeed, the drag created by trade was the primary reason for the less-than-stellar 1.1% performance of the second quarter. Losses from trade alone shaved roughly 2.5% from growth over the period.

Moreover, at least some of those losses could be from importers who were stockpiling ahead of a possible dock strike, and will be given back later in the year.The result is an economy that grew closer to 3% (pending further revisions) during the first half than the 4% initially expected, but one that is still set for reasonable growth going forward.

What's Next?

Many on Wall Street have jumped to the conclusion that the world must be a significantly worse place than we thought, and therefore are touting "double-dip" recession scenarios. As we have stressed many times, the immediate past often sets the stage, but not the trajectory for where we are moving next. Indeed, there is ample reason to believe that growth will reaccelerate in the third quarter, and more in the fourth (see Chart 3):

*--Seasonally adjusted annual rate.

  • Monetary policy remains "accommodative," with the Fed willing to ease further if a credit crunch seems imminent (although one would be hard-pressed to find a credit crunch among consumers (who comprise two-thirds of the economy) or small businesses (who employ two-thirds of the workforce);
  • Fiscal policy is stimulative, aided by the War on Terrorism and a complete lack of spending restraint ahead of mid-term elections;
  • The unemployment rate remains relatively low, and income growth remains positive;
  • Profits are improving (in fits and starts), despite confusion and panic over accounting crises on Wall Street;
  • Equipment spending has picked up, especially in areas important for productivity growth and profits--information technologies; and,
  • Inventory replenishment still has a long way to go, which will spur additional production.

The only major concern is continued weakness in the stock market, which can be traced more to a crisis in confidence than deteriorating economic conditions. Indeed, our analysis suggests that equity markets are undervalued, and have a substantial upside, given the modest economic recovery we have already experienced.

Moreover, if financial markets continue to ignore the underlying economic fundamentals and create a self-fulfilling crisis in credit, the Fed will intervene. The Fed still has 175 basis points to spend if it really needs to, and would not hesitate to use them if a credit crunch seemed imminent or the recovery appeared to be truly faltering.

Indeed, the forecast for a retrenchment of the Fed's earlier easing has been pushed back as a result of the benchmark revisions. The Fed is now expected to wait until 2003 to make an aggressive move to normalize rates, or "neutralize" monetary policy. (A neutral policy stance implies that the Fed is not actively trying to stimulate or inhibit growth. It is believed that a Fed Funds rate in the 4% range would be "neutral."

Finally, recent stock market woes have reopened the door to mortgage refinancing, as investors have retreated to the perceived "safety" of bonds over stocks. The result is record low mortgage rates and another surge in refinancing activity. (See Chart 4.) The estimates are preliminary, but it looks like consumers will create somewhere between $40 and $50 billion in spending capacity during the current round of mortgage refinancing. The question is whether it will be spent.

The Proof Is In The Pudding

Vehicle sales, which are highly correlated with refinancing (it seems people like to fill their garages along with their homes), surged back toward record territory in July. The return of incentives were also a help, but had less explanatory power than mortgage refinancing. Incentives in July were only up an estimated $400 from a year ago, when sales were lackluster.

The Bottom Line

The economy remained remarkably resilient in 2001, despite recently revised growth estimates. The U.S. is not Japan: our consumers continued to spend, and the recession remained exceedingly mild, despite the bursting of the NASDAQ bubble, the give-back from Y2K, and the disruptions created by September 11.

Moreover, the revisions did little to alter the forecast for a re-acceleration of growth in the second half of 2002 and into 2003. The characteristics of that recovery, however, are likely to more closely resemble those of the early 1990's than other recoveries. Growth rates will be respectable, but pale when compared to those of a more traditional bust/boom cycle, and economic gains will be driven more by productivity than payroll increases.

The good news is that the recovery will not be as painful for Main Street as in the early 1990's because we are starting from a much lower level of unemployment. It is simply easier for the economy to absorb a "jobless recovery" with unemployment around 6% than 8%. (In this context, the term "jobless recovery" refers to a recovery that generates fewer jobs than one would expect in a recovery. As a result, the unemployment rate will likely rise more before it falls, and its decline will not be as dramatic as in past recoveries. On the upside, we are starting from a lower level of unemployment than in the early 1990's, which will temper the pain of few new jobs.)

Also, Wall Street should eventually benefit. There is little doubt that equity market values will be significantly higher in 12 to 18 months from now than they are today. The only catch is timing the turn.

Finally, there is a strong argument that the statistical agencies would have made fewer errors in their original growth estimates had they been given the funding they needed in the first place. Fewer errors mean a more timely and accurate understanding of the U.S. economy, potentially better policy decisions, and smaller revisions later. In fact, if policymakers had been as informed as they are today about what was happening in the second half of 2000, they might have been able to be truly preemptive and avert a recession entirely.

A Crisis In Funding

This is the second time in history that the BEA "missed" a recession as it was happening. The first occurred in 1990-91, with disastrous consequences for policymaking decisions: Monetary policy was tight and fiscal policy was restrictive as we were entering the recession. This time around, policymakers were more cautious, and took what were thought to be preemptive strikes against a recession (once bitten, twice shy). One can only imagine how history might have been altered if the entire picture leading up to 2001 had been available in a more timely manner.

The issue is especially important today, as Congress shapes the 2003 budget. Just three weeks ago, the Senate Appropriations Committee decided to delete $10.7 million in funding (a small amount given the potential benefits) for improving the quality and timeliness of U.S. economic data. Moreover, the funding that was requested was earmarked to fix problems in the very places where revisions to the data were largest areas where the agencies must rely on external, rather than internal, sources.

Funding for the U.S. statistical agencies is lumped in with the funding for Homeland Security. But how secure are we if we can't make wise business and economic policy decisions? This ability is being severely compromised by such short-sighted budgeting. We are justifiably asking for corporate CEO's to certify the quality of the profits that they report. Shouldn't we expect the same high standards for information from our government?

The Bank One Financial Model

Due to popular demand, the Corporate Economics Group (CEG) has resumed printing its financial market analysis. Readers of One View and its predecessor First Forecasts will remember the model for the critical role it played in calling the 1987 market crash and recovery, the rebound from the global financial crisis in 1999, and the technology bubble.

The CEG uses a statistical model to track the U.S. stock market s progress relative to the economy. The core approach of the model is based on the simple idea that two classes of forces drive overall equity prices: 1) Economic fundamentals profits, interest rates, the business cycle, productivity, and other economic factors; 2) Internal market dynamics non-economic forces, generated by the equity market itself.

S&P 500

The CEG model uses only economic fundamentals. The result is illustrated in Chart 5. As one can see, economic fundamentals imperfectly track the actual behavior of stock prices. Also notice, however, that equity prices, given time, always return to levels consistent with economic fundamentals. In other words, the model is telling us that the S&P 500 currently sits 28% below levels consistent with economic fundamentals. And, if history is any indicator, this gap will eventually close.

The current, pronounced stock market volatility is the consequence of direct competition between economic fundamentals and internal market dynamics. The economy is recovering, but investors are concerned about the transparency of financial reporting. Investors who are concentrating on the accounting scandals, however, are making a mistake. Current economic fundamentals feature extraordinarily rapid productivity growth, reflecting basic, underlying structural changes in the U.S. economy. These changes not transparency issues associated with accounting practices will determine the direction of equity prices in the coming years.

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