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September 2004 — Vol. 82, No. 7

COVER STORY

Will the recovery last?

 

Economists say the U.S. economy’s coattails will be taking Connecticut’s along for the ride. That’s always the case, more or less. But this time around, the state isn’t being dragged down by as many of its own problems as it was during the last recovery.

“This is not 15 years ago, when we had huge real estate overhangs and banks were on the brink. ... We don’t have that today,” says Nick Perna, economic adviser to Webster Bank. Now, he says, “The biggest risks are the risks that could derail the national economy.”

What are those risks? And is the national recovery strong enough to withstand them? If it is, will Connecticut be able to keep pace?

Recovery now ‘self-sustaining’

Mark Zandi, chief economist and co-founder of Economy.com in West Chester, Penn., sees the U.S. economy as “strengthening. It’s much improved from a year ago, but not back to where it was in 2001 in terms of jobs, real household income and real household net worth,” he says. But, he adds, “GDP now is actually better than it was then.

The recovery has become “a self-sustaining expansion,” says Zandi. “We’re now creating enough jobs to generate consumer spending. And we’re no longer dependent on government stimulus,” he says, referring to the Federal Reserve Bank’s decision in June to reverse its three-year trend of lowering interest rates.

The Federal Reserve raised rates in June by 0.25% to counteract signs of inflation. Explaining that decision, Federal Reserve Board Chairman Alan Greenspan told Congress in July, “The considerable monetary accommodation put in place starting in 2001 is becoming increasingly unnecessary.” As he noted, “Not only has economic activity quickened, but the expansion has become more broad-based and has produced noticeable gains in employment.”

Private nonfarm job growth averaged about 200,000 a month in the first half of 2004, he said, up sharply from roughly 60,000 a month in the fourth quarter of 2003. The improved job market, he added, would likely encourage household spending.

Consumer spending is tied to consumer confidence. And, according to Lynn Franco, director of The Conference Board’s Consumer Research Center, “Consumer confidence is driven primarily by the labor market. If we continue to see improvements in employment levels, confidence should stay strong.”

It’s good news, then, that more than 80% of the CEOs responding to a June survey by the Business Roundtable, an association of CEOs of the nation’s leading corporations, said they “expect their U.S. employment to increase or remain steady,” according to the association’s president, John Castellani.

Speaking at the National Conference of State Legislatures in July, Castellani said, “America’s CEOs believe that the U.S. economy will continue to grow and add jobs. Clearly, the economic trends are headed in the right direction, showing the level of strength that goes with self-sustaining growth.” He added that “close to 90% of the CEOs expect sales to increase” this year and that the Busi-ness Roundtable members “expect real GDP to reach 3.7% for 2004.”

Economy.com’s Zandi is more optimistic. He forecasts GDP will grow 4.5% this year and 3.5% next year.

Terrorism weighing on‘collective psyche’

Despite the overall optimism about the national recovery, “considerable uncertainties remain about the pace of the expansion and the path of inflation,” Greenspan told Congress. “Some of those uncertainties, especially ones associated with potential terrorism, both here and abroad, are difficult to quantify,” he said.

The threat of terrorism is “the most pressing [risk] that weighs on the collective psyche,” says Zandi.

There’s also a feeling that the economy keeps taking two steps forward and one back. “The economy is on a growth curve. But it’s not a smooth curve — it’s a little choppy,” says CBIA Economist Peter Gioia. “May’s jobs figures were strong, but June’s came in below expectations, as did July’s establishment [private nonfarm employment] survey. However, July’s household survey, which covers all types of employment, including self-employment, was quite strong,” he says.

In addition, the manufacturing sector grew in July for the 14th month in a row, while the overall U.S. economy grew for the 33rd consecutive month, according to the Institute for Supply Management.

“The concerns are — and we’ve seen this reflected in the stock market — that the risks to continued growth appear to be growing,” Gioia says. “The strongest concern is over energy and the vulnerability of energy to price spikes.”

Bruce Blakey, economist and manager of market research for Northeast Utilities System, agrees. The recovery, he says, is “vulnerable to international crises that could adversely affect energy prices and/or consumer confidence. Interna-tional crises are the biggest risks to a continued recovery.”

Crude oil concerns

The economic impact of international crises was very evident this summer. On July 28 the price of crude oil hit a 21-year high of $43 per barrel when it appeared that a financial crisis would shut down one of Russia’s largest producers. The next day the price eased off when that crisis was averted, but then it surged even higher — to nearly $44 a barrel — after the U.S. government raised the terror-threat level in the country’s major financial areas. The following day, the price set another record, topping $44 per barrel.

Prices that high are a real cause for concern. “Crude oil at more than $40 per barrel has a negative effect on economic growth,” says J. Alan Day, economist and senior investment manager at Banknorth Wealth Management Group. For one thing, it means consumers “pay more at the pump. Unless we get a pay increase, we’ll have to cut back on other spending,” says Day.

Zandi agrees. “Forty-dollar-plus-per-barrel oil is a problem. It cuts into household income and business profits. But not only energy prices are high; prices of other commodities — copper, platinum, lead — are high too.”

A recent survey by CBIA and the Connecticut Association of Purchasing Management bears that out. Eighty-two percent of the respondents reported paying higher prices for the principal items they purchase, compared with 56% a year ago.

Inflation increasing

Higher commodity prices are one of several factors behind the recent uptick in inflation, according to Alan Greenspan.

“Consumer prices, excluding food and energy — so-called core prices — have been rising more rapidly this year than in 2003,” Greenspan noted in his report to Congress. The reasons, he said, include:

  • “the indirect effects of higher energy prices on business costs”;
  • “increases in nonoil import prices that reflect past dollar depreciation and the surge in global prices for primary commodities”; and
  • “a marked rise in profit margins” due partly to “the recent recovery of demand after a couple of years during which weak demand led to relatively heavy price discounting by businesses.”

But, he added, “businesses are limited in the degree to which they can raise margins by raising prices.” One thing already affecting margins is a pickup in labor costs. “Although advances in productivity are continuing at a rate above the long-term average, they have slowed from the extraordinary pace of last summer and are now running below increases in hourly compensation,” he said.

For the first half of the year, hourly compensation increased at an annual rate of about 4.5%, due to “continued sizable increases in health insurance costs, a sharp increase in business contributions to pension funds, and an apparently more robust rate of growth of hourly earnings of supervisory workers,” said Greenspan.

The slight rise in labor costs, though, “does not appear to threaten longer-term price stability,” Greenspan said. What’s more, “there is little evidence that the price-containing forces of ever-widening global competition have ebbed.”

Nevertheless, Greenspan indicated that additional rate increases were likely. (In August, the Fed did raise rates again, by another 0.25%.)

Is there a danger the Fed will raise rates too much or too fast?

“No. The Federal Reserve will tighten [monetary] policy in a way that won't undermine the expansion,” Zandi believes. “The risk that they will overdo the tightening is small.”

Greenspan in July said future rate increases would probably occur at a modest pace that businesses and consumers should have no trouble adjusting to.

He pointed out that the historically low interest rates of the past few years have allowed businesses and consumers to refinance their debt. “Businesses have been able to fund longer-term debt at highly favorable interest rates,” he said. “House-holds have made similar adjustments.”

Still, “Lower- to lower-middle-income consumers are stretched” in regard to debt, says Zandi. “That becomes more of a problem as interest rates rise.”

Nick Perna, economic adviser to Webster Bank, though, says, “I’m not really worried about consumer debt — that will only be a problem if there’s another big problem.

Fearing deficit fallout

One thing that does worry Perna is that “the nation faces some risks from the huge budget deficit. He says, “We could face much higher interest rates than we’re otherwise likely to see as the Fed tightens up over the next year. The budget deficit could cause a slowdown, even a recession,” he says.

“I think we’ll see concrete fallout from this problem. It could be a few days out, or a few years out,” Perna says. “No matter who gets elected [president], they’ll have to deal with it. We’re seeing more and more bipartisan concern.” To lower the deficits, he predicts, “You’re going to see some federal taxes, or you’ll see some spending cuts. But there’s not a lot to cut, politically. The issue of taxes isn’t going to go away. If you’re waiting for more cuts, you’ll have a long wait.”

“Basically,” he concludes, “I’m worried about three things: oil, terrorism and financing the U.S. budget and trade deficits. Although, if the economy continues to do well, that will help deal with the problem of the deficits.”

Connecticut recovering weakly

A thriving U.S. economy would also bode well for Connecticut and New England.

“Depending on the strength of the national economy,” notes Rae Rosen, chief economist and assistant vice president for the Federal Reserve Bank of New York, “the state is well set for a moderate recovery.”

Right now, Rosen adds, “We’re in the early stages of a slow recovery. For most of the Northeast, income has picked up but job growth has been slower than it has nationally. Both in the U.S. and Connecticut, rising productivity has dampened the need for new jobs. That’s a double-edged sword: In the long run, we’ll live better, but in the short term it can dampen job growth.”

“As in prior business cycles, Connecticut has weakly followed the national recovery,” says Northeast Utilities’ Blakey. “The recovery formally began several years ago with income growth, but employment growth is just now occurring in Connecticut.”

According to Zandi, “Connecticut is lagging significantly. It’s having a great deal of difficulty, for several reasons:

  1. The state’s cost structure is very high in terms of business and living costs. Businesses are increasingly interested in locating where costs are lower. High costs affect the ability to create jobs.
  2. The insurance industry is continuing to struggle in the search for higher productivity and higher profitability.
  3. The state continues to lose older households that are looking for a place to retire. That puts a pall on the economy.”

And, although the state’s unemployment rate (4.6% as of June) is below the U.S. rate (5.6%), Zandi notes that “people who become unemployed in Connecticut don’t stick around. They’re highly educated and will move to other areas for jobs.”

One good omen is that “we’ve seen [consumer confidence] conditions improve in New England,” says The Conference Board’s Franco. “Compared with a year ago, there has a been a big improvement. That’s true in consumers’ assessment of the present situation and their expectations for the next six months. The higher level of confidence in the present situation shows recovery is under way.”

“In the Northeast,” Rosen says, “we expect the recovery to strengthen, job growth to pick up and unemployment to slowly inch down. Over the next 18 months, we’re on a pretty solid track in the Northeast.

“Of course,” she adds, “any state could shortcut its recovery by passing antibusiness legislation.”

Positioning Connecticut to prosper

But the state can do more than avoid harming its recovery. Although the state can’t influence the strength of the national recovery, it can set itself up to take full advantage of a recovering U.S. economy, economists and business leaders say.

“Seeing that the local economy is driven by the national economy, state government cannot ensure that the recovery will continue. Larger forces will

overwhelm any short-run efforts by state and local government,” says Blakey. “That said,” he adds, “local governments can tighten their fiscal processes and develop long-run economic development plans that will allow us to better weather future recessions and perform better during expansions. To illustrate, the electric transmission system in Connecticut should be upgraded to ensure adequate supply at the lowest possible costs to Connecticut businesses.”

Other business cost areas — such as health benefits, workers’ and unemployment comp, taxes and regulatory compliance — are also in the state’s power to improve, says CBIA Executive Vice President John Rathgeber. So are longer-range problems like transportation and education.

“The state needs to adopt policies that encourage business investment and job creation here,” he says.

Gov. Jodi Rell has said she intends to do just that. She will, of course, need the cooperation of the General Assembly — which is why CBIA is informing legislative candidates about the most crucial business issues they should address if elected (see CTbizVotes.com).

With the state’s help and Washington’s efforts to thwart terrorism, tame inflation and encourage economic growth, both the Connecticut and U.S. economies should find themselves in full recovery.

 

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