Gulf War Charts

ECONOMIC TRENDS
Prepared by Federal Reserve Bank of Cleveland
The Economy In Perspective
(March 2003) War...As this goes to press, war with Iraq appears more likely than it did last month--indeed, it seems nearly imminent. It is difficult to quantify the effects on the U.S. economy of the tension surrounding a possible war or the war itself. Who can gauge how much capital investors are willing to risk until uncertainties are dispelled? Who can reliably estimate the cost of fighting this war without knowing its duration or scope? And who can predict the reaction of neighboring states now and in the future? In fact, considering the many possible ramifications of war and its aftermath, the economic consequences sometimes seem quite beside the point. As essayist Susan Sontag put it, "War-making is one of the few activities that people are not supposed to view 'realistically'; that is, with an eye to expense and practical outcome. In all-out war, expenditure is all-out, unprudent--war being defined as an emergency in which no sacrifice is excessive."
No market registers the threat of a Middle East war more clearly than energy. Crude oil traded at roughly $20 per barrel from 1992 through 1997. Prices shot up to $35 per barrel late in 2000 at the peak of a worldwide economic boom, but fell back to $20 per barrel when the boom collapsed early in 2002. Since then, global economic conditions have continued to deteriorate, but crude oil prices have doubled to $40 per barrel. Rapidly rising energy prices are a red flag to economists because oil price spikes preceded virtually every recession in the last 50 years. It is true that during this time the United States has significantly improved its energy efficiency in terms of Btu's per dollar of output and that the relationship between oil prices and economic activity might be changing. Nevertheless, the United States now depends on imported oil more heavily than ever. This is obvious to everyone with interests in the Middle East, which explains recent energy price movements.
Quite apart from rising geopolitical tensions, the U.S. economy is adjusting to the collapse of the high-tech boom and the stagnation of its important trading partners' economies. Despite the gradual acceleration of the U.S. economy, regaining its footing is proving harder than many anticipated. Low interest rates have stimulated housing sales and enabled households to bolster their spending through mortgage refinancing, but there are obvious limits to how long this process can continue to propel the economy. In any event, these low interest rates also reflect a large supply of saving relative to investment demand: Capital spending has not yet picked up materially.
Capital spending bears close watching. Some analysts claim that it will continue to strengthen this year as obsolete capital depreciates and increased production gradually lifts capacity utilization rates. Other analysts argue that capacity utilization rates are so low that new capacity will not be required for some time; moreover, even productivity-enhancing investments might be postponed to protect corporate cash flow. Historically, capital spending has been closely related to capacity utilization, and since a wide range of industries still have substantial amounts of excess capacity, it seems reasonable to doubt that capital spending will strengthen immediately.
Capital spending nicely illustrates the links between past, present, and the anticipated future. Today's buildings, equipment, and employee skills reflect past choices. Today's decisions about how to use these resources will determine the nation's future labor quality and capital stock, and to reach these decisions we must conjecture about the future. Expectations of the future profoundly affect the present and therefore influence the future itself. With war tensions in the air, our present and future--so very dependent on one another--are still up for grabs.
Global trading patterns and financial markets are rerouting the rivers of world politics and commerce, sweeping the United States into the very evolutionary currents it is promoting. The Middle East maelstrom looms dead ahead, fraught with danger and with promise. No one knows where it will lead or what will follow.
Inflation And Prices
The Consumer Price Index (CPI) jumped an annualized 4% in February, well above its recent trend of about 2-1/2%. Virtually all of the month's retail price acceleration came from energy prices, particularly gasoline. The highly volatile energy sector has caused wide fluctuations in U.S. households' monthly cost of living over the past several years. Between late 1999 and early 2001, for example, inflation in the prices of petroleum products rose to a peak of more than 50% before plunging downward last year, at times showing declines of more than 20%. These large swings in energy costs have certainly been the major contributor to acceleration--then deceleration--of the CPI's growth rate during the period. And it appears that energy prices are once again helping to propel the CPI upward. Over the past 12 months, home fuel oil prices have risen about 20%, and gasoline prices about 30%.
Are such large swings in energy prices a major disruption to household budgets? Yes, but less than they used to be. Over the past 22 years, energy costs as a share of total household expenditures have fallen dramatically. Gasoline and motor oil, which accounted for about 5% of consumers' expenditures in 1980, are only about 2% of their expenditures today. Even so, a 30% increase in gasoline prices translates into a monthly increase of roughly $32 in U.S. households' gasoline costs unless consumers change their driving habits.
Whether the recent rise in energy costs will continue much longer, or even worsen, is unknown. Continued uncertainty about the availability of petroleum from Iraq is contributing to a run-up in energy costs, including gasoline, aggravated by the curtailment of refined oil from Venezuela. Indeed, wholesale gasoline prices on the spot market have risen to about $1.05 per gallon, matching the peak reached in 2000. This pattern is especially troubling in light of the recent slip in domestic gasoline inventories. Gasoline stocks, which approached a 24-day supply at the end of February, are shrinking--at a time of year when they usually expand in anticipation of the summer driving season. Still, futures markets appear relatively optimistic about the outlook for energy costs, including gasoline, over the course of 2003; prices are expected to fall to around 80 cents per gallon by year's end.
Does the potential for rising energy costs suggest that the inflation outlook is deteriorating? Probably not. Rising energy costs may pinch household budgets this spring, but inflation--a persistent decline in the purchasing power of money--still seems well contained. Notably, two core inflation measures, the CPI excluding food and energy, and the median CPI, continue on the downward trajectory they began late in 2001. And neither households nor economists project any major change in retail price trends over the next year or so. Consumers expect prices to rise about 3%, close to their five-year inflation expectations. Economists see the CPI rising between 2% and 2-1/2% over the next four quarters, a bit lower than its recent 12-month trend.
Monetary Policy
On February 11, the Board of Governors released its semiannual Monetary Policy Report to the Congress, which noted that although "the economy remained sluggish at the end of 2002 and early this year," the household sector "continued to be a solid source of demand." Improved outlooks for business, the current leanness of inventories, rapid productivity growth, and fiscal stimulus at the federal level "are expected to lead to a faster pace of economic expansion, while inflation pressures are anticipated to remain well contained."
Since the last meeting of the Federal Open Market Committee on January 28 29, implied yields on federal funds futures have not moved strongly. Over the last few months, market participants have pushed back the date at which they expect the next round of tightening to begin.
On January 9, the Federal Reserve implemented significant changes in its discount window lending policy. Under the new policy, Reserve Banks extend short-term primary credit to qualified institutions at an interest rate that is currently 100 basis points above the intended federal funds rate. Before this change, the rate on similar loans typically was below the fed funds rate. The new regime replaces the old system of rationing credit at the discount window with one that extends primary credit with "no questions asked." The changes are designed to reduce the stigma of discount window use and to lower variability in the fed funds rate by capping it at the primary credit rate. However, we have yet to see a reserve shortage large enough to drive the fed funds rate up to the primary credit rate. When such an event occurs, qualified institutions are expected to turn to the discount window to borrow at the more attractive primary credit rate rather than push the funds rate even higher to avoid borrowing from the Fed.
The Monetary Policy Report presents a set of semiannual economic projections by the Board of Governors and Reserve Bank presidents. How do these projections compare to those of private forecasters? If the summary statistics of projections were exact, a scatter plot of actual versus summary statistics would show points lying along a 45-degree line. The same is true of the unemployment rate, except that there are some significant misses.
The Report's accuracy can be compared to private forecasters' and to a naive forecast predicting that a variable's future value will equal its current value. At a 12-month horizon, the average absolute error of professional forecasters' unemployment projection is 0.55% versus the Fed's 0.41%. Both of them fare better than the naive forecast, whose average absolute error is 0.73%.
Although the Fed's projections for real GDP growth and inflation track the actual values fairly closely, there are periods when the actual values lie well outside the range of projections. Predicting GDP growth in the last five to ten years has proven particularly difficult.
Money And The Financial Markets
At the short end of the maturity spectrum, interest rates tend to follow the federal funds rate closely. With the fed funds rate unchanged through much of 2002, the three-month Treasury bill held fairly steady. However, all short-term rates fell markedly when the fed funds rate was cut 50 basis points in November. Risk spreads in the commercial paper market barely increased during 2002 and remain low, probably because lower-quality issuers are exiting the market. The amount of commercial paper outstanding dropped nearly one-third in 2002 and continues to decline this year.
Long-term interest rates have fallen modestly since late last year, probably as a result of lower long-term inflationary expectations. After peaking in the summer of 2002, risk spreads on corporate bonds retrenched near the end of the year. Risk spreads on speculative-grade corporate bonds have increased in the last few months and remain at historically high levels, reflecting low recovery rates for bonds in default as well as lingering concerns over corporate governance. On the other hand, interest rates on AA-rated corporate bonds have fallen below those on 10-year Treasury notes.
Although increasing home prices have added to household wealth over the last couple of years, declining equity prices have more than offset this effect. The wealth-to-income ratio has fallen more than a percentage point since its peak in late 1999. The last two years have witnessed tremendous volatility in the personal saving rate, caused partly by savings' adjustment to the phase-in of tax cuts implemented by the Economic Growth and Tax Relief Reconciliation Act of 2001.
Household borrowing expanded swiftly in 2002--overall consumer debt levels rose more than 9% during the year, the largest increase since 1989. Mortgage debt grew more than 11% in 2002. Despite these increases, the debt-service burden, expressed as a percent of disposable income, did not rise appreciably. Large gains in disposable income and low mortgage rates helped to contain debt service burdens.
Consumer loan quality at commercial banks continues to improve. During 2002, delinquency rates on credit cards, residential real estate loans, and other consumer loans fell. However, delinquency rates on credit cards continue to be elevated at nearly 5%. Despite the overall strengthening of credit quality, loan officers at commercial banks report tighter credit conditions for consumer loans.
The Conference Board's Index of Consumer Confidence and the University of Michigan's Index of Consumer Sentiment fell in February. Although they have reached the lowest levels seen since late 1993, both indexes remain somewhat higher than they were in the early 1990's.
International Oil Markets
Oil, the world's single most important energy source, is in limited supply. The global economy depends on oil producing nations to provide a steady, reliable supply. About 40% of world oil production is supplied by the Organization for the Petroleum Exporting Countries. OPEC was formed in 1960 by Iran, Iraq, Saudi Arabia, and Venezuela to maintain stability in the oil market for the benefit of producers and consumers. Today, OPEC's 11 members collectively possess more than three-quarters of the world's total crude oil reserves and supply 55% of the oil traded in international markets.
The dominant OPEC member is Saudi Arabia, which has been the world's largest oil producer since 1993 and accounted for more than 11% of world oil production in 2002. Each of the other major members--Iran, Venezuela, Nigeria, and the United Arab Emirates--accounted for somewhere between 3% and 5% of world oil production last year.
As a major oil producer, OPEC exercises a powerful influence on the oil market, increasing or decreasing production in response to falling or rising oil prices. Its members set output limits or quotas for regulating oil supply in order to stabilize price movements. Recently, because of the geopolitical situation in Iraq, production shortages in Venezuela, and declining petroleum stocks, the world market price for oil has risen significantly. In response, OPEC has set production levels above its former limits. In February 2003, all its members except Indonesia and Venezuela were exceeding their quotas to counteract upward price pressure. Current prices are well above OPEC's ceiling of $28 dollars per barrel, so the organization will have to increase production still further to bring prices back below that ceiling.
The U.S., the world's largest importer of oil, buys more than 60% of its total oil consumption abroad. The major suppliers of oil to this country are Canada, Mexico, Saudi Arabia, and Venezuela, which collectively account for about 56% of U.S. oil imports.
Oil prices' volatility recently doubled compared to the early 1990's. Petroleum import prices rose 68.6% between January 2002 and January 2003, after falling 39.5% in the previous calendar year. The spot price of West Texas intermediate crude rose 35% between December 2002 and February 2003, when it reached $37.70, the highest price since the Gulf War.
Wide oil price fluctuations introduce uncertainty into business and personal decision making, so it is not surprising that futures markets have arisen to mitigate this risk. Futures prices are sometimes considered a good predictor of spot prices. One-month futures contracts seem to track spot prices fairly well, with futures prices highly correlated (0.9) with the spot. Currently, prices for one-month futures contracts indicate that oil prices will remain high through March. It is much harder, however, to predict oil prices a year ahead from the futures market. One-year futures prices do not track spot prices very well and are only weakly correlated (0.15) with them.
Economic Activity
According to the preliminary estimate, real gross domestic product (GDP) grew at an annual rate of 1.4% during 2002:IVQ. A decline of 8.5% (annual rate) in durable goods spending dampened quarterly personal consumption growth. Business fixed investment, however, reversed its trend of the past four quarters, increasing 2.5% (annual rate). Although government spending boosted output growth by $20.7 billion (1996 chained dollars), the decline in net exports was nearly twice that amount.
February's preliminary estimate doubled the 0.7% annual rate of real GDP growth reported in January's advance estimate. Personal consumption, business investment, residential investment, and government spending all contributed more to real GDP growth than initially estimated. Contributions from exports and imports were both revised downward. Among the major components, inventory change showed the most substantial revision. The contribution from changes in inventories increased from -0.6 percentage points to 0.2 percentage points. During the first half of 2002, inventories declined in all sectors compared to the previous year, but retail inventory growth began to pick up in the latter half of the year. In 2002:IVQ, retailers posted solid year-over-year inventory growth, and manufacturers and wholesalers decelerated their inventory cuts.
After the revision, the real GDP growth rate for 2002:IVQ was still only about half of its long-term average of 3.0% (annual rate). However, the Blue Chip forecast calls for improved growth throughout 2003.
Business fixed investment's nominal share of GDP has fluctuated around 10% over time, but its real share has risen sharply because a real dollar of GDP today buys much more quality-adjusted capital than it did 10 years ago.
The 2001 recession is unusual in that capacity utilization, which typically is much higher than its long-run average when a downturn begins, was close to its postwar average. The same phenomenon occurred in the 1990 downturn; it may be related to managers having better information, which enables them to time investment according to their capital needs. However, unlike the previous downturn, this time better information did not prevent capacity utilization from dropping to a low similar to other postwar recessions.
Changes in the investment rate are correlated with the level of capacity utilization. When capacity utilization is high, the investment rate tends to pick up; low levels of capacity utilization are associated with a slowdown in the investment rate. An anomaly of this recovery is that the rate of change in investment appears to be reviving much earlier than capacity utilization, which remains near the cycle's low.
One way to measure the severity of the recent recession is to compare capacity utilization's performance since the last business cycle peak with its performance in previous cycles. Capacity utilization started out relatively strong in the latest downturn, but lately has approached its average level for this stage in a cycle. In that respect, it has behaved like the unemployment rate, which also did better than average shortly after the last peak but has since fallen much closer to its average.
Labor Markets
In February, nonfarm payroll employment fell by 308,000 jobs, the biggest monthly decline since November 2001. January's numbers were revised upward by 42,000. Job losses were widespread and severe: 104,000 in goods-producing and 204,000 in service-producing industries. Wholesale and retail trade posted the largest decline, 93,000 jobs. Construction, hurt by poor weather in February, declined by 48,000 jobs, compared with January's increase of 26,000. Manufacturing employment, in its thirty-first consecutive month of losses, fell by 53,000; this is consistent with the industry's average monthly decline in 2002. Services employment, which increased for most of 2002, fell by 86,000, its worst monthly decline since November 2001. Transportation and public utilities' net loss of 41,000 jobs brought the total to about 500,000 jobs since March 2001.
The unemployment rate inched up to 5.8%, 0.1 percentage point higher than last month and equal to the 2002 average. The employment-to-population ratio fell 0.1 percentage point to 62.4. The four-week moving average of initial unemployment insurance claims, a leading economic indicator, rose to 408,750 for the week ending March 1. This, its fifth consecutive increase, reflected the labor market's contraction. Initial claims, which hit a 25-year low in April 2000, rose by 166,000 this January. Since March 2001, this statistic has varied around a benchmark level of 400,000, peaking at 482,000 in October 2001.
Employment Changes
So far, the labor market has shown little evidence that the economy is recovering. In fact, many labor market indicators have not changed discernibly since the recession began in March 2001: Labor force participation for both men and women continues to decline. The fraction of those working or looking for work has dropped 1.0 percentage point for men and about 0.5 percentage point for women. The fraction of the population that is employed has also fallen for both sexes. And the unemployment rate has crept up from roughly 4.3% in March 2001 to its current 6%.
Job losses have not been evenly distributed among occupations. Women suffered significant losses in three categories: precision production (10%), operators and laborers (9%), and farming (6%). Men also took their biggest job loss in precision production, but it was only about 4%. Men also showed losses in technical and managerial occupations. The industries that posted gains were services (men and women) and farming (about 8% for men).
In December 2002, only one category--managers--showed roughly equal shares of men and women. About 30% of employed men and 30% of employed women are in managerial occupations. However, the share of women in technical and service occupations was nearly double the share of men.
The Ohio Budget
In January 2003, Governor Taft presented his biennial budget for the State of Ohio's fiscal years 2004 and 2005, which reflects the state's economic difficulties over the last two years. Budget changes include elimination of five state programs, reductions in state employees, a zero pay increase for state workers over the next two years, and an implied increase in their costs for health care insurance.
Roughly half of Ohio's collected revenues have restrictions on the way they are spent; these funds usually are authorized by the state legislature for special projects. In Ohio, transfers from the federal government for social welfare projects are part of the general fund, since the state has some discretion in distributing welfare dollars. The rest of the general fund typically is collected from income, sales, and property taxes. The governor has proposed substantial tax code changes that would reduce income tax rates for most individuals (and consequently would cut tax revenues), but he has also proposed widening the scope of other taxes to accommodate this change.
General fund appropriations offer a glimpse into the executive branch's political priorities. Governor Taft highlighted the importance of education in presenting his budget, which directs nearly 40% of the state's general fund toward education programs. The budget also reflects the rising cost of health care: Medicaid and other health and human services will comprise more than 45% of state spending in 2004 05, compared with 42% in 2002 03.
Since his tenure began, Governor Taft has tried to build a budget stabilization fund (commonly called the "rainy day fund") equal to roughly 5% the of state's general fund in any fiscal year. The stabilization fund's purpose is to allow the state to avoid cutting services to Ohio citizens despite any revenue shortfall caused by poor economic circumstances. Although the 2002 03 budget originally called for maintaining the fund near 5% of general revenues in 2003, the state was forced to use the balance of the fund to respond to its budget deficit. The governor did not budget any dollars for the fund in 2004 but planned to resume contributions in 2005.
In 2003, Ohio's government faces a budget deficit of between $651 million and $720 million. So far, the government has eliminated 3,000 jobs plus $121 million in departmental spending and state employee pay raises, but this year the state legislature refused to authorize the revenue-generating taxes that the governor suggested to address the remaining deficit (somewhere between $120 million and $189 million).
This shortfall could have an immediate effect on secondary and higher education: The governor has suggested that it will be necessary to cut funding to balance the budget for fiscal year 2003. This would compound Ohio's fiscal crises in higher education; state funding was cut severely in 2002 and remained below 2001 funding levels in 2003, resulting in large year-over-year tuition increases at state schools in both 2002 and 2003. Primary education funding could face cuts equal to 2.5% of each school district's state dollars this year. In several counties, this would mean losing more than $2 million.
Credit Unions
Federal credit unions are mutually organized depository institutions that provide financial services to their members. Like banks and savings associations, which were discussed in recent issues of this publication, credit unions seem to be consolidating. Their number fell from 11,238 in 1997 to 9,814 in 2002:IIQ. Over the same period, however, credit unions' total assets rose 53%, going from $352 billion to $539 billion. Their membership also increased steadily from 71.4 million in 1997 to 80.3 million in 2002:IIQ.
The growth in credit unions' total assets was fueled by a 43.7% improvement in loans issued, which rose from $232.3 billion in 1997 to $333.6 billion in 2002. This growth was remarkably strong in the early 1990's but tapered off toward the end of the decade. Year-over-year loan growth increased slightly to 7.7% at the end of 2002:IIQ.
Shares, which are analogous to deposits in banks and savings associations, are credit unions' primary source of funds. They too have been rising steadily since 1997. After peaking at 15.3% in 2001, shares' growth rate fell slightly to 13.1% in 2002:IIQ. This is still much higher than rates' single-digit growth in 1999 and 2000, which resulted from high stock market returns in 1998 and 1999. In later years, investors made a flight to safety, reallocating money from more risky investments to insured credit-union share accounts. Economic improvement and increased optimism could lead investors to take money out of share deposits and reinvest it in the equity market.
Credit unions' net worth continued to improve steadily, rising from $38.93 billion in 1997 to $57.02 billion by 2002:IIQ, an increase of 46%. Since 1998, the annual growth rate of net worth has remained flat at around 8%-9%. This is no surprise, considering that retained earnings are credit unions' only source of net worth.
Mirroring the flat growth of net worth, the return on assets has been unchanged at around 1% since the late 1990's. Although this is nowhere near the 1.4% return that credit unions offered in 1992, it is still a success given that the ratio between gross income (interest, fee, and other operating income) and average assets dropped from 8.4% in 1997 to 7.2% in 2002. Credit unions maintained their profitability primarily because they reduced operating expenses per dollar of assets and because the cost of funds fell sharply as a consequence of monetary policy actions since 2001.
Because growth in net worth could not keep up with asset growth, the ratio of net worth to total assets decreased from 11.4% in 2000 to 10.6% as of June 2002. Still, the health of the credit union industry appears to be good. Delinquent loans as a percent of assets fell from 0.67% in 1997 to 0.45% in June 2002. In other words, by June 2002, credit unions had more than $23 for every $1 of delinquent loans.
Thus credit unions remain viable providers of basic depository institution services such as consumer loans, checking accounts, and savings accounts.
Foreign Central Banks
On March 6, the European Central Bank reduced its target interest rate by 25 basis points (bp) to 2.5%. Geopolitical developments associated with Iraq continued to make the economic outlook particularly uncertain. That said, however, incoming information suggested further weakening. In Europe, speculation about policy easing intensified, as shown by a significant decline in implied yields for futures contracts on the Euro Overnight Index Average. In Japan, nomination of the central bank's new governor was widely, though not universally, thought to imply continuation of recent years' monetary policy approach; this approach centered on a massive buildup in the quantity of base money, almost entirely matched by enlarged holdings of idle balances at the bank.
In the Americas, Venezuela imposed exchange controls in early February, pegging the bolivar to the dollar at a rate about 20% below the recently recorded market peak. Brazil's central bank raised its interest rate target by 100 bp to 26.50%, the fifth of the increases that have added 850 bp to the target since last July. The Bank of Mexico also tightened policy in early February, repeating January's 75-million peso increase in the reserve shortage. In addition, Mexico's government issued the first-ever sovereign bond under New York law with a collective action clause that allows a 75% majority to bind all holders to revised repayment terms in a default. Widespread adoption of such a feature is an oft-cited characteristic of a new, more stable global financial architecture.
March 2003 Federal Reserve Bank of Cleveland P.O. Box 6387, Cleveland, Ohio 216-579-2000 www.clevelandfed.org