US: An extraordinary decade

THE PAST decade has been extraordinary for the American economy. The synergies of key technologies markedly elevated prospective rates of return on high-tech investments, led to a surge in business capital spending, and significantly increased the underlying growth rate of productivity.

The capitalisation of those higher expected returns boosted equity prices. This contributed to a substantial pickup in household spending on a broad range of goods and services, especially on new homes and durable goods. This increase in spending exceeded even that of the enhanced rise in real incomes.

*Though demand for a number of high-tech products doubled or tripled annually, in some cases new supply was coming on even faster.

High-tech capacity glut: The overall capacity in high-tech manufacturing industries rose nearly 50 per cent last year, well in excess of its already rapid rate of increase over the previous three years. A temporary glut in these industries and falling prospective rates of return were inevitable at some point.

*Clearly, some slowing in the pace of spending was necessary and expected if the economy was to progress along a more balanced growth path.

*Inventories of semiconductors and computers have fallen, but less progress appears to have been made with respect to communications equipment.

*Overall, inventory investment of high-tech producers has probably turned negative, but a period of substantial liquidation still appears ahead for these products.

Stress on profits/cash flow: The demand for capital equipment, however, is more problematic. Despite evidence that expected rates of return on the newer technologies remain high, investment in equipment and software has slowed. But the weakening appears to have gone beyond this adjustment, reflecting a deterioration in short-term profitability and cash flow.

*Pressures on profit margins and cash flows have been unrelenting. The earnings estimates of securities analysts for the S&P 500 in 2001, which presumably reflect the guidance that these analysts are getting from corporate management, have been revised downward by nearly 1 per cent per week since February.

*Earnings weakness is evident pretty much across the board but especially for high-tech firms, where the previous extraordinary pace of expansion has left oversupply in its wake.

High-tech still growth area: Despite the marked softening in the flow of new orders into high-tech manufacturing firms in recent months, the level of these new bookings was still higher than in early 1999, a period of emerging euphoria.

*At some point, one hopes sooner rather than later, the high-tech correction will abate, and this set of industries will re-establish itself as a solidly expanding, though less frenetic, part of our economy.

*At that point, rather than returning to the outsized 50 per cent annual growth rates of last year, a more sustainable pace should be expected.

Near-term downside: There are also downside risks to consumer spending over the next few quarters. Importantly, the same downward pressure on profits and the heightened sense of risk that have restrained investment have also lowered equity prices and reduced household wealth. We can expect the decline in wealth that has occurred over the past year to restrain household spending relative to the growth of income.

Behind rate cuts: Nominal and real long-term corporate rates eased off somewhat in June and July and then were stable until much later in the year. This stability suggested that a rough balance between investment and saving plans was being foreseen by the markets. Asset prices lose their upside potential and come under downward pressure as investors re-evaluate risk and revise expectations for outsized gains.

*A bursting speculative bubble has historically too often been the end result of this process. Identifying bubbles and their ultimate demise is exceptionally difficult.

*In reducing the federal funds rate this year by 250 basis points in a compressed period, we have been responding to our judgment that a good part of the weakening of demand was likely to persist for a while.

Policy effect with lag: The effect of our recent policy initiatives will take time to strengthen financial portfolios and spill over into demand for goods and services.

*We also need to be aware that our front-loaded policy actions this year should be providing substantial support for a strengthening of economic activity later this year.

*We are experiencing only a pause in the investment in a broad set of innovations that has elevated the productivity to a level significantly above that of the two decades preceding 1995.

*New broadened applications of innovative technologies should again strengthen demand for capital equipment and restore solid economic growth.

Edited observations of the US Federal Reserve Chairman, Mr Alan Greenspan, on recent `economic developments' before the Economic Club of New York on May 24.