"A reverse soft landing" is how William C. (Curt) Hunter, senior vice president and director of research, Federal Reserve Bank of Chicago, characterizes the current economic situation. In a reverse soft landing, he says, "the economy goes down below potential, then it comes back gradually. This is not a bad thing. We need to wring out some of the excess, particularly in capital spending (on high-tech equipment)."

Hunter was one of two economists to present his outlook to purchasing managers attending NAPM 's 86th annual international purchasing conference and educational exhibit held recently in Orlando, Fla. Also on the economic panel was Michael P. Niemira, vice president and senior economist, Bank of Tokyo-Mitsubishi, Ltd.

The economy has performed at very high levels for a long time, says Hunter. "It has been truly dramatic and quite impressive. We've had rapid growth, low inflation and low unemployment. It's been a Holy Grail of economic activity."

In showing annual increases of 4% since 1997, the economy was growing at or above its potential, says Hunter. What's more, good monetary policy helped exploit the situation.

Throughout second half 1999 and first half 2000, the economy was growing at a 6% rate, which Hunter says is excessive. "We started to see some early signs of accelerated inflation. Oil prices were rising. The rest of the world started to come back in terms of growth rates. All this was putting a lot of pressure on global resources. So, in an effort to curb accelerating inflation, the Fed started a program of rate hikes to slow down the economy."

Then, from July through September "we had a gradual slowing, probably in line with projections, followed by a rapid downturn in October and November caused by rising energy prices, bad weather, and excessive inventory in the high-tech sector. Consumer confidence took a hit."

In 2001, "we had a good first quarter, with the economy growing at 2%. This is better than many people thought," says Hunter. "The trade situation helped, but we also had strong consumer spending." Still, the economist is concerned about the sharp decline in imports. "Consumers may be retrenching even more as they consider their spending plans."

During his presentation, Hunter used the Chicago Fed's National Activity Index to back up his forecast.

The Index is based on a weighted average of 85 economic data series from five categories: output and real income, employment and hours, personal consumption and housing, manufacturing and trade sales, and inventories and orders. The Index includes NAPM 's Purchasing Managers' Index as well as five of its component diffusion indexes: production, new orders, supplier deliveries, inventory and employment. In the Chicago Fed Index, the NAPM data have a weighted average of 9%.

Designed to measure current economic activity and provide early warnings on future inflationary pressures, monthly and three-month moving averages are calibrated so that zero puts the economy at its potential. In other words, a zero reading means the economy is growing, with no inflationary pressures. Readings above zero indicate the economy is expanding above its potential, which if persistent, will lead to inflationary pressures. Values below zero indicate the economy is slowing and, if the value continues to fall below potential, shows an economy heading into recession.

The Index started to slow in terms of potential in July 2000, says Hunter, and it continued to fall through February. "That's indicative of the state of the economy."

A reading of -0.91 for February suggests that the economy was in a state of weakness and subject to increasing probability of entering into a recession, Hunter says, emphasizing the fact that the economy is not now in recession. (A reading of -0.63 for March suggests that the bottom of the current downturn has been passed. For that reading, most of the indicators showed improvement, with NAPM 's Purchasing Managers' Index improving by a tenth of a point to 43.2%.)

Other indicators show that manufacturing remains weak (although inventories are coming down, which is good for the sector), consumer spending and housing are moderating, capital spending is down sharply, and inventory adjustments are under way.

The Chicago Fed Index, which goes back to 1967, has been accurate in reporting the past five recessions, says Hunter. "We are not anywhere near the levels of past recessions." In 1991, the value was -1.8; in 1982, it was -2.45; in 1980, -3; and 1974, -4. Probability of recession at the index's reading for February is about 40%.

"The index is below where it was in 1995 and 1996 when the Fed had tightened interest rates in response to inflationary pressures," says Hunter. "When the economy slowed, the Fed started to ease up to bring the economy back. Of course, at the time, the economy did turn back up. Most of the recent data (industrial production, NAPM 's PMI) will help turn the index back up. The current situation mimics 1995 and 1996 when the economy averted a recession by proper easing and it is starting to come back.

Hunter forecasts a 1.5% to 2% growth rate for second quarter, with the economy coming back in the second half.

Agreeing with Hunter that the U.S. economy is not in recession, Mike Niemira, vice president and senior economist, Bank of Tokyo—Mitsubishi Ltd., sees parallels between the current economic situation and 1990, the last time he spoke at an NAPM annual conference.

He characterizes the situation then and now as a "growth recession" or economic slowdown.

Although the Fed lowered interest rates six times for a total of 200 basis points before the 1990 "classical" recession, the U.S. business cycle retraction still occurred, Niemira explains. "The Fed lowered interest rates 200 basis points earlier this year to ward off a classical recession and concerns about the economy still exist."

Although the economy is not now in a classical recession (two successive quarters of negative growth or declines), Niemira says that the U.S. economy entered into a slowdown or growth recession in July 2000, which continues. Some slowdowns, he says, turn into recessions, while others can encompass periods of moderate expansion. "But, it also may be misleading to extrapolate from any slight improvement and embrace the popular view that since an inventory correction is under way that the second half of the year will see economic growth accelerate."

The current economic slowdown is not a result of an inventory bulge or higher interest rates, says Niemira. "The U.S. economy saw waves of higher energy prices, which cut into discretionary purchasing power. Motor vehicle sales, for instance, peaked in February 2000. And while the industry recently increased production, risks for the sector persist in the near term."

At the same time, the long investment boom has ended. The problem now, says Niemira, is that without an improvement in economic fundamentals, a recession is likely to take hold by midsummer and continue through year-end. "The Fed cannot prevent recession, but it can moderate the downside. The type of recession that I foresee is consistent with the business cycle tracking of the past. The average contraction during a U.S. recession was about 3% at an annualized rate."

Still, volatility of the U.S. economy has been reduced substantially since 1983, says Niemira. "As inflation has come down so too has volatility of economic growth. In a more stable environment, corporate forecasting is easier. General economic imbalances are less likely to develop."

Low volatility is associated with higher spending and lower savings, which Niemira explains as the Katona Effect (named for George Katona of the University of Michigan). The Katona Effect, which provided evidence for the economic boom of the 1990s, also correctly predicted the consumer spending slowdown last year.

Consumer spending is based on consumer ability and willingness to spend. This holds true for business investment as well. Consumer confidence reflects a willingness to spend, while the ability to spend is captured by income measures. "Confusing the public with its undue emphasis on confidence alone," Niemira says, "the Fed often overlooks reasons for deterioration in consumer confidence, such as concerns about inflation (in this case, higher energy costs).

"The risk of recession is very high, but we are not in recession right now. However, recession risk is likely to rise further. Higher energy prices are cutting into willingness and ability to spend for both businesses and consumers."