Toward Another "Soft Landing"
The nation's longest economic expansion on record is now in its 119th month (February 2001, starting from April 1991). For this, the Federal Reserve can claim some credit. Moreover, the character of the slowdown appears quite favorable to continued growth over the long-term, barring an unforeseeable economic shock. Moderating growth in consumption coupled with growth in business investment can be expected to produce sustainable growth in an environment characterized by low unemployment, low inflation, and solid productivity growth. This fortuitous combination supports the Committee staff's outlook for continued but slower growth of 2.4 percent for 2001.
A Portrait of a Slowdown
The high flying national economy has decelerated from growth of 7.0 percent in the second half of 1999 to growth of 5.0 percent in 2000. The slowdown is occurring approximately one year after the Federal Reserve's first interest rate hike in June 1999, although a few signs appeared earlier. With private sector borrowing costs at their highest levels in a decade at the end of 2000, the economy's slowdown is most visible in such interest rate-sensitive sectors as construction and durable goods manufacturing. While the unemployment rate remains low, jobs have actually been lost in the nation's manufacturing sector. Other signs of slower growth include declines in hours worked, inventory build-ups, and reductions in some prices at the wholesale level.
The slowdown is being led by consumers, who pulled back from spending growth of 7.9 percent in the first quarter of 2000 to growth of 2.9 percent for the second quarter, 4.6 percent for the third quarter, and 2.7 percent in the fourth quarter. While it appears consumers are indeed responding to the Federal Reserve's six interest rate increases (prior to the shift in policy on January 3 of this year), it is not clear precisely through what channels. The second quarter saw a significant financial market correction. Are consumers responding directly to an increase in borrowing costs, or are they responding to the impact of higher rates on the value of their stock market wealth?
Trends in Business Investment
In contrast to the moderation in consumption growth, private business investment appears to remain relatively solid, as firms continue to invest in information technologies expected to increase efficiency and, hence, profits. These layouts have resulted in increased purchases of computers and other durable goods orders, particularly those related to business-to-business infrastructure building. Growth in private fixed-investment spending for equipment and software accelerated during the first half of 2000 to 19.2 percent from 14.7 percent for the first half of 1999. This combination of lower consumption and continued strong investment may represent the best of all possible worlds for the Federal Reserve. With spending growth strongest in areas that will ultimately increase productivity, we can expect continued growth without a dramatic acceleration in inflation over the long-run. Since it takes time for technological changes like those we are now witnessing to disseminate throughout the entire economy, we can expect this process to remain ongoing.
Need there be a concern that the Federal Reserve may have overshot its target and that the economy may slow too much? Although consumer confidence has dropped to the lowest level since 1996, with unemployment remaining low and the ratio of household net worth to disposable income still high, and despite a much tamer stock market, there is little reason to believe that consumption growth will fall enough to threaten the viability of the expansion.
The Committee staff expects consumption growth to continue to moderate into 2001. Growth of 2.8 percent for 2001 is expected to follow 5.4 percent growth for 2000. This moderation in consumption will be accompanied by continued growth in investment of 4.3 percent in 2001, following growth of 10.3 percent in 2000.
Soft Landing II
The debate among economists still centers around how successful the Federal Reserve will be in once again engineering a soft landing. Our persistent low-inflation, low-unemployment environment-the hallmark of the new economy-may indeed be here to stay for some time to come. Business cycle expansions can be expected, on average, to be longer, and recessions to be shorter and less painful than those before 1982. This phenomenon is largely due to four factors: the economy's shift away from manufacturing towards service production; the careful monitoring of the Federal Reserve; the forces of global integration; and the resurgence of productivity growth.
Historically, there has been a close relationship between attempts by the Federal Reserve to slow the economy and the onset of an economic downturn. Contractionary monetary policies, which raised the federal funds rate and, consequently, other short-term interest rates, have been associated with national recessions with only three exceptions. Only during 1966, 1984, and the current expansion (circa 1995) did the Federal Reserve successfully manage soft landings-or moderate slowdowns with no recession-enabling the U.S. economy to experience its two longest post-war expansions. For example, real GDP grew by 6.6 percent in 1966, but was reduced by the Federal Reserve's actions to a weaker but positive 2.5 percent in 1967. Similarly, real GDP grew by 7.3 percent in 1984, but slowed to 3.8 percent in the following year. Real GDP increased by 4.0 percent in 1994, but fell back to a 2.7 percent pace the following year. The first soft landing of the current expansion followed seven interest rate hikes over a 13-month period between February 1994 and February 1995; what is potentially our second soft landing of the current expansion followed six interest rate hikes over a 12-month period between June 1999 and May 2000.
Managing Economic Cycles
Research results published several years ago by Data Resources, Inc. (DRI) indicate that during the post-World War II period, the national economy exhibited a decisive response-either an official National Bureau of Economic Research cyclical peak or a soft landing-to the Federal Reserve's interest rate hikes with an average lag of 13 months. In December 2000, we were in the nineteenth month of monetary tightening. Although annual GDP growth remained relatively high, the growth rate on a quarterly basis has been somewhat reduced. For example, GDP grew by 4.4 percent in both 1997 and 1998, and increased by 4.2 percent in 1999 and 5.0 percent in 2000; however, the quarterly rate has come down from a meteoric 8.3 percent in the final quarter of 1999 to a 4.8 percent and a 5.6 percent rate in the first and second quarters of 2000, and only 2.2 percent in the third quarter, and just 1.4 percent in the fourth quarter-the weakest pace since 1995.
The question remains: Will the Federal Reserve be able to manage yet another soft landing as it did in 1966, 1984, and 1994-without producing a recession this year? Or are current economic conditions too different from those that existed in prior years? Did the Fed wait too long to change its policy stance and reduce interest rates on January 3 of this year? The Federal Reserve continues to scrutinize the economy's rate of expansion and price growth with vigilance, ready to act on any signs of inflationary pressure. The Fed successfully engineered a soft landing for the national economy by raising short-term interest rates seven times between February 1994 and February 1995. These actions effectively turned the clock back, giving the current expansion more of the characteristics of a young, rather than a mature, expansion.
Thus, by the middle of 1999, the Federal Reserve was faced with a situation similar to the one in early 1994-growth was so strong that it could potentially threaten price stability. In June 1999, the central bank shifted its policy stance yet again in order to slow the economy's momentum. The federal funds target rate was raised six times between June 1999 and May 2000. However, with consumer confidence down from record highs, along with consumption growth and the public's appetite for technology stocks slowing, the Federal Reserve, in its most aggressive easing move since 1982, cut interest rates twice in January 2001 in order to ensure the continuation of the current expansion. The Fed can be expected to further reduce interest rates this year in two moves (totaling 50 basis points) in order to keep the economy on track for a soft landing in 2001.
The Federal Reserve was sufficiently encouraged that economic growth was slowing enough to keep inflation in check that they decided to leave interest rates unchanged at their November 15, 2000 meeting. Given that decision, a key interest rate controlled by the Federal Reserve-the federal funds rates-stayed at 6.5 percent, the highest level in nine years. It marked their fourth meeting in a row in which the Federal Reserve passed up the chance to raise rates for a seventh time. The Fed left interest rates unchanged at its October 3, August 22, and June 28 meetings, citing signs of moderating economic growth. The prime rate stood at 9.5 percent, its highest level since January 1991 when the country was in its last recession.
As of early December 2000, one would have expected that over the ensuing six months, the recent interest rate hikes would further slow the growth in consumption, especially in the case of consumer durables. Then-current interest rates would also have been expected to reduce housing market activity. Nonresidential investment, however, was expected to remain healthy despite the higher interest rates, as firms continue technology-related spending. Export growth was expected to pick up momentum as the East Asian economies recover and revive their demand for U.S. goods.
As the month of December 2000 progressed, however, the economy appeared to slow beyond that which was anticipated by both the financial markets and the Fed. With manufacturing orders down, inventories up, consumer sentiment falling, and the stock market dropping, it appeared the economy was heading toward a hard landing. In an effort to forestall a "premature" end to our current expansion, the Fed cut interest rates on January 3 between the regularly scheduled meetings (i.e., without warning). This sent a strong signal: the Federal Reserve policy stance had indeed shifted and the objective was now to prevent the current softening of the economy from progressing into a contraction/recession/hard landing. The Fed followed-up with another rate cut at its regularly scheduled meeting at the end of January, thus producing the most aggressive easing move since 1982.
Some economists believe the U.S. economy is skirting a recession much more closely than expected if we were indeed experiencing a soft landing. In fact, the drop in household wealth and consumer confidence, in addition to the slowdown of the rate of growth in business investment, does threaten to turn the soft landing into a crash landing.
It may be useful to compare the state of the economy to an airliner that is preparing to land. As the plane enters the stage of flight when it is making the transition between a descending flight path and one which is parallel to the ground, it is in an extremely vulnerable position.
A delicate balance of factors is acting on the plane-the exchange of lift for weight on the ground, decreasing thrust, and increasing drag work to slow the aircraft. Even the slightest adjustment in throttle can transform a smooth landing into a bumpy one. Any change in external conditions-a sudden wind gust-requires a quick reaction from the pilot. If necessary, the pilot can adjust course or even abort the landing, but such action requires dependable information and immediate, decisive response. Depending upon the many factors acting upon the aircraft, the result can be a continued smooth landing, or a bumpy, hard-or crash-landing. Similarly, if the Federal Reserve does not carefully monitor the economy, or is slow to respond to any unforeseen changes, the economy could very quickly transition away from a soft landing.
Productivity and Profit Growth in the New Economy
The most significant force propelling the U.S. economy forward is the ongoing process of technologically transforming itself from an energy-based to an information-based economy. This transformation is evident in the profound growth of investment in computer and computer-related hardware and software. U.S. businesses spent more than $2 trillion on computers, software, and other technological products during the 1990's. In 1999 alone, corporate spending on technology grew 22 percent to $510 billion, accounting for more than 40 percent of all business investment. This high rate of growth defies predictions made in 1999 that computer-related spending would trail off as Y2K preparations wound down.
Three key components of nonresidential fixed investment spending which enable enhanced productivity growth are investment in computers, software, and communications. For the past three years, spending on software has far-exceeded spending on the other components, and is expected to continue to do so in the future. In 2001, for example, businesses are expected to spend roughly 50 percent more on software than on computers, and roughly 45 percent more on software than on communications equipment.
These substantial increases in U.S. capital investment, particularly when compared to the growth in the size of the labor force, explains a large part of the acceleration in productivity growth over the past five years. The U.S. Department of Labor, Bureau of Labor Statistics reports that productivity growth for the nonfarm business sector rose 4.3 percent in 2000, a significant acceleration from the 2.9 percent growth experienced for all of 1999, and the largest annual increase since 1983 (see Figure 6). The Committee staff expects productivity growth for the nonfarm business sector to be 2.9 percent this year, which is consistent with the reduction in the rate of GDP growth expected.
A study by the Federal Reserve confirms that much of the jump in productivity growth since the mid-1990's can be explained by investment in new information technologies. By now, much attention has been paid to the use of information technologies to better manage and reduce the need for large stocks of inventories. In addition, the companies that produce computers and the embedded semiconductors appear to have achieved major efficiencies in their own operations, boosting productivity growth for the economy as a whole. The study concludes that the use of information technology and the production of computers accounted for about two-thirds of the one percentage point rise in productivity growth between the first and second halves of the 1990's. The study's authors estimate that much of the remainder reflects the improved managerial practices that have resulted from innovation-driven technological change.
Productivity growth has allowed firms to experience increased earnings in the face of intense competitive pressures by reducing the growth in the cost of producing goods and services. Moreover, despite a huge increase in the supply of high-tech capital assets, there is little evidence of a noticeable reduction in prospective rates of return on the newer technologies. These high rates of return permit firms to earn solid rates of profit growth despite the absence of price flexibility. The Committee staff projects after-tax profit growth of 1.4 percent for 2001, following strong growth of 12.8 percent for 2000.
Inflation and the Internet Economy
Much of the technology investment we now witness is related to business firms further integrating the Internet into both their production and sales management systems. Businesses are using information-based systems more and more extensively to conduct and re-engineer production processes, streamline procurement processes, and manage internal operations. Firms are also utilizing Internet resources to reach new customers, with manufacturers and wholesalers who once only engaged in business-to-business transactions now developing a retail capacity as well.
Has the growth of the Internet economy had the promised downward impact on inflation? Easily accessible information about what competitors around the country are charging for the same goods, as well as easy access to those goods online, should enhance overall economic competitiveness with consumers reaping the benefits in the form of lower price growth (see Figure 7).
How Internet Sites Impact Conventional Retailers
Numerous studies show prices for many products are, indeed, lower when purchased via the Internet. For example, one study concluded that books and compact disks cost an average of 9 to 16 percent less on websites than at conventional retailers, based on 8,500 prices posted over a 15-month period ending in May of last year. Another researcher compiled an Internet price index of eight different types of products, ranging from pharmaceuticals to clothing. The total basket of goods was 13 percent cheaper online than offline, including shipping charges. Prescription drugs were 28 percent cheaper and apparel 38 percent cheaper.
In addition, although Internet retail sales still comprised about one percent of total U.S. retail sales, the Web can also force prices down at conventional stores. For example, although only three percent of all car buyers actually purchase their vehicles over the Internet, about half of all buyers now use the Internet for research. This impact may be visible in several components of the consumer price index, such as that for new cars, which has been flat or negative for the past three years.
However, the ease with which information on prices can be attained, in some cases, lead to higher prices. Retailers can get quick access to prices being charged by their competitors, making them better able to judge when the market will bear a higher price. As one economist has written, the structure of the market itself may ultimately determine whether the Internet will lead to higher or lower prices. In markets where there are many competing sellers, there will tend to be more downward pressure on prices. Where there are only a few sellers, low-cost information about what they are charging could, perversely, lead to higher prices. With price information widely available, it becomes easier for suppliers to "coordinate" their pricing, thus avoiding competition.
Market structure can be expected to have a similar impact in the booming online business-to-business market. In a market where there are few buyers and many sellers, easy access to price information is likely to work for the benefit of the buyers-pushing down prices. But where there are few sellers and many buyers, the availability of timely price information may well have the opposite effect-pushing prices up.
On balance, the Committee staff expects the growth of the Internet economy to act as a restraining force with respect to inflation. That, along with continued high rates of productivity growth, will help to move the economy to a rate of inflation of 2.7 percent for the current year, following consumer price growth of 3.4 percent for 2000. This is consistent with the gradual filtering of higher energy prices through the economy last year.
The Economy and Energy
The most significant source of uncertainty surrounding the forecast for consumption is the future price of energy. With stocks of heating fuel particularly low, it is expected that energy will take a large bite out of consumer budgets this winter, especially in the Northeast. In addition, natural gas prices have risen dramatically, causing a significant increase in both heating costs and the cost to produce electricity in the U.S.
The recent increase in the price of natural gas is best explained by demand-supply analysis. Following several years of warmer-than-average winters, which reduced the demand for natural gas and thus depressed the price, the Northeast returned this year to a more normal (colder) winter weather pattern. Supply has not kept up with demand.
This situation is exacerbated by the increased reliance of electric utility generators on natural gas. As new electric utility generating plants come online in the U.S. in order to meet increased demand for electricity (owing to both increased use of computers and other electricity-driven high-technology devices, and for other residential needs), additional demands are placed on the already-strained supply of natural gas. Unfortunately, some feel much of the promised generation capacity that is supposed to save electricity markets from crisis will never be built-largely due to insufficient gas supplies. The result may very well be an electricity market in short supply, with price spikes and electricity shortages during the peak demand periods.
According to a recent report by Salomon Smith Barney (SSB), the consensus view that power plant development now underway will reduce electric prices is mistaken. According to SSB's Power/Gas Team, the proposals for new plants that have been announced fails to keep pace with expected electric demand growth in the U.S. SSB calls the availability of natural gas "the critical factor" when discussing the ability of electric generators to meet the expected levels of future demand.
In the long-run, the price of crude oil is expected to settle somewhere between $25 and $30 per barrel, significantly below the $34 per barrel where it was at the end of 2000. However, in the short-run, we suspect that the energy crunch now facing the nation and the world may play a role in 2001 similar to the role which the Asian financial crisis played in 1998. High energy prices are expected to act as more of a brake on consumption growth than a harbinger of inflation. Therefore, the Federal Reserve is not expected to have to engage in any further monetary tightening. Indeed, if the global economic expansion is sufficiently derailed by an inadequate supply of energy, such as that currently being experienced by California, the Federal Reserve may have to be prepared to lower rates further.
Recent Producer Price Index data shows that the high prices of energy are starting to be felt in core producer prices, however, the effects remain small. If energy prices remain at or near their year-end 2000 level, we will see energy costs put pressure on core inflation. Indeed, there is good evidence that energy prices will not reverse course easily. Therefore, inflationary pressures will not likely subside quickly as it takes some time for the effects of high energy prices to show up in the core index, as businesses try to pass on higher costs.
The implications for the Federal Reserve's monetary policy are that there is no need for an immediate tightening. However, the Fed will watch for any sign that high energy prices translate into rising core inflation.
Effects of Increasing Energy Prices
How is the U.S. economy going to be impacted by this turn of events in the energy price arena? The altered structure of the U.S. economy, which is now centered in services rather than energy-intensive manufacturing, and our growing use of other forms of energy such as natural gas, electricity, and coal, has helped ease our dependence on oil. However, the Energy Information Administration estimates tell us that petroleum supplied 39 percent of our energy needs in 1998. Clearly, the U.S. is still quite dependent on crude oil. While it is unlikely that the current upsurge in oil prices will plunge the U.S. economy into a recession, a prolonged increase will undoubtedly have a significant impact on the U.S. economy as corporate profits decline, inflationary expectations rise, and consumer confidence erodes-slowing down the economy. Given these factors, the question of how long these high oil prices will persist remains an important one.
Since OPEC had agreed to increase oil production by only 800,000 barrels a day at the Vienna meeting in September 2000, we certainly could not have expected a sustained price decline in the short-term. Inventories of gasoline, distillates, and heating oil had been low at the end of 2000 compared to the year-ago period. Low gasoline inventories going into last summer precluded rebuilding distillate stocks, thus setting the stage for a potential shortfall in distillate supply entering the peak demand season in the winter months. Despite a return to below-average winter temperatures, oil prices have declined since early this year owing, in part, to a softening world economy and a resultant weaker-than-expected demand. At the most recent OPEC meeting on January 17, the decision was made to cut production by 1.5 million barrels a day (5 percent) effective on February 1 in order to prevent a sustained drop in crude oil prices, which had fallen to just over $25 a barrel. So, it appears unlikely that oil prices will average much below $30 per barrel in the near term.
The longer-term outlook, however, appears more optimistic. Some non-OPEC oil producers in Canada, Latin America, Mexico, the U.S., Southeast Asia, and West Africa have started drilling projects, and if the high price is sustained, others may follow suit. Moreover, while it is in the interest of OPEC to keep short-term prices high, member countries would not want their market share to be eroded, and oil prices to collapse, especially if the global economy were to slow down. Since there is a 12- to 18?month lag between expanding output from existing fields and getting oil in the tanker, and the non-OPEC producers had only just begun their drilling activities in mid-2000, we can expect an impact on price only by around mid-2001.
The strength of the dollar is yet another factor contributing to the relatively low rate of inflation enjoyed by the U.S. economy in recent years. However, that very strength, combined with the sluggish rates of growth for the nation's major trading partners, has engendered a trade deficit that continues to break records month after month. The declining dollar value of the euro combined with higher energy prices does not bode well for demand for U.S. exports.
On the upside, the global economy is very likely to experience in the decade ahead the same technology-led boom which has been underway in the U.S. for some years. The rapid pace of technology spending is likely to result in increased productivity growth throughout the global economy in the years ahead, increasing the demand for U.S. exports and reducing the U.S. deficit over the long-run.
The outlook for the international economy improved significantly in the first three quarters of 2000. Merchandise exports to the nation's two largest trading partners, Canada and Mexico, rose 9.5 percent and 33.7 percent, respectively, during the first three quarters of 2000. Overall, U.S. exports fell by 4.3 percent in the fourth quarter of 2000, following growth of 13.9 percent in the third quarter and 14.4 percent in the second quarter. However, imports rose by 0.5 percent, 17.0 percent and 18.5 percent, respectively, during the same periods. Furthermore, the monthly trade deficit has widened to set new monthly records throughout most of last year.
Despite the U.S. record current account deficit relative to GDP, the foreign currency value of the dollar has been rising, on average, since the end of 1999. This means that the dollar exchange rate has moved in a direction which promotes the growth of imports relative to exports. The dollar's appreciation suggests that, all things being equal, the U.S. trade deficit will set new record highs.
The Dollar Remains Strong
The relatively robust U.S. economy, and its strong currency, should continue to buoy import volumes. United States exports have rebounded from their 1998 lows despite declines in shipments to sluggish Latin American economies, other than Mexico. Perhaps the biggest problem is with the Asian economies, which accounted for roughly half of the U.S. trade deficit for the first half of 2000; trade deficits with China and Japan accounted for about one-third of the deficit. The major deterioration, however, has been against the OPEC countries as a result of rising oil prices.
At the present, one of the biggest obstacles to closing the U.S. trade deficit is the weakness of the euro vis-a-vis the dollar. Why had the euro recently plummeted to its lowest value since its inception in January 1999? According to a study by the International Monetary Fund, such economic fundamentals as interest rate differentials and the relative strengths of the respective economies can explain only about half of the euro's plunge since early last year. The weak euro fuels inflation in European Union (E.U.) countries by making imports more expensive, but is beginning to create export jitters in the E.U.'s biggest trade partner, the United States. A wider trade deficit could undermine the U.S. economy and the value of the dollar, unless the E.U. can rival U.S. growth rates.
The strength of the U.S. dollar also reflects the unprecedented inflow of foreign capital into the U.S. economy. Large amounts of foreign direct investment have helped to sustain a robust pace of capital expenditures. Of the nearly $25 trillion of the U.S. outstanding debt obligations in 2000, 11.0 percent is owed to foreigners, compared to 5.7 percent in 1987. When improved investment opportunities arise elsewhere, the world's demand for the financial and real assets of the U.S. will ebb.
Despite a generally ambivalent outlook for the global economy for 2001, two forces will act to restrain U.S. export growth. One is the rise in oil prices, which appears to be having a more disruptive impact in Europe than in the U.S. The other is the slowdown in the U.S. economy in response to the Federal Reserve's six interest rate hikes, to the extent that foreign economies have come to depend on U.S. consumers. Concern over what happens to the world economy once U.S. consumer spending returns to more historic levels helps to explain equity market declines in Korea, Singapore, Hong Kong, Mexico, Brazil, and Japan.
On balance, the impact of higher energy prices on the global economy, as well as the weak euro, will produce weaker growth in U.S exports in 2001 than we saw in 2000. The Ways and Means Committee staff expects export growth to fall from 9.2 percent in 2000 to 6.0 percent in 2001. At the same time, imports are projected to grow 8.7 percent in 2001, down from the 2000 rate of 13.7 percent. With import growth in 2001 continuing to overwhelm growth in exports, we expect yet another record trade deficit.
Wall Street and Bonus Income Growth
In 1999, a number of records were broken on Wall Street. The securities industry saw their pre-tax profits surge to a record $16.3 billion in 1999, up 68 percent from 1998's $9.7 billion level, and far exceeding the prior record level of $12.2 billion reached in 1997. The industry also saw year-end bonuses rise by over 23 percent to nearly $12 billion. In addition, U.S. securities industry revenues set a new record at $183 billion in 1999, and initial public offering activity (IPO) set a new record at $69 billion. The robust financial markets also were responsible for strong gains in security and commodity brokerage jobs. Although New York City continues to hold the dominant share of the U.S. jobs in security and commodity brokerage, that share has dropped from 34 percent in 1990 to 26 percent in 2000.
Despite the recent slump in the U.S. equities markets, the record-setting pace of Wall Street activity continued in the 2000. Although pre-tax profits for the fourth quarter are expected to be 29 percent lower than the third quarter of 2000, the figure is expected to come in at $3.5 billion. This compares to $5.2 billion in the second quarter of 2000, and a quarterly record of $8.2 billion in the first quarter of 2000. And while lower, the fourth quarter 2000 profits are good enough to bring the full year 2000 domestic profit figure to $22.0 billion. This represents a new record level of profits, exceeding 1999's full-year record of $16.3 billion by 35.0 percent (see Figure 8).
The Federal Reserve interest rate hikes between June 1999 and May 2000 designed to slow the level of growth in both the aggregate economy and in asset prices had caused the market to falter and were a large factor in the third and fourth quarter 2000 declines (see Figure 9). Indeed, many segments of the securities business, including mergers and acquisitions, will be negatively affected as the impact of the interest rate hikes through mid-2000 filter through the economy. Fourth quarter 2000 profits came in extremely weak, and new records won't likely be set in 2001, as the current profit environment becomes tempered by layoffs from ongoing mergers and acquisitions, and anticipation of further consolidation in the financial services industry in the fourth quarter 2000 and the current year. This trend slowed growth in employment and compensation costs as 2000 drew to a close.
The slowing of industry profits growth is likely to have implications for bonus income earned by industry employees, and hence, for New York State income growth. Securities industry bonus payments are the driving force behind State bonus income overall. In addition, since bonus income tends to be taxed at the highest marginal tax rates, a decline in bonus payments can be expected to have a negative impact on State revenues.
Although bonus earnings growth for the fourth quarter of 2000 may not have kept up with the record-breaking pace of the recent past, it is still nevertheless expected to be large by historical standards. Wall Street's banks and brokerages are expected to have set a record high for employee bonuses in 2000, paying a total of $13.3 billion. New York City's world-leading financial sector thus improved upon the prior record of nearly $11.8 billion in bonuses paid in 1999.
Throughout the 1990's, mergers and acquisitions have been a significant source of revenue for both Wall Street firms and those legal enterprises that service these firms. Despite some volatility of the stock and bond markets, the merger and acquisition activity has remained quite strong.
The financial markets appear confident that the Federal Reserve is committed to maintaining a low inflation environment. This confidence is evident in the strong bond and stock market growth we have experienced for the last four years. As the world's financial capital, New York City's economy has benefited from the recent surge of financial market activity. For instance, the securities industry had relatively strong job gains in the second quarter of 2000, and the average salary for this industry is $180,000. In addition, the vacancy rate for the commercial real estate market declined significantly in the second quarter of 2000 compared to the same quarter last year, based on data published by Cushman and Wakefield.
In addition, the financial market firms derive their revenues from a broad variety of sources other than stock trading. One of the most lucrative of these activities is the management and underwriting of mergers and acquisitions.
Mergers and Acquisitions
Mergers and acquisitions should continue to be an important source of Wall Street profits for the foreseeable future. In 1999, the value of mergers and acquisitions completed was $1.3 trillion, which was only slightly lower than 1998's record level. In 2000, the value of mergers and acquisitions completed was $1.7 trillion, which was 30.8 percent higher than in 1999 and a new record-high level (see Figure 10).
Factors responsible for the sustained level of merger and acquisition activity include the following:
Collectively, the above factors should continue to exert their influence for the near future. Thus the mergers and acquisitions business can be expected to contribute to a healthy year on Wall Street, even in the event of slower growth in the securities market.
- Increasing globalization-which has encouraged firms to consider strategic cross-border mergers and acquisitions as companies seek to improve their positions in the global market.
- The rapid pace of technological change has caused large firms who have traditionally relied primarily on their own innovations and internal research and development (a slow and expensive process) to attempt to gain immediate access to a desired technology by acquiring another firm.
- Changes in the regulatory environment have also encouraged growth in the mergers and acquisitions market-as the U.S. Justice Department has tended to approve deals that it would have prevented a few years ago, preferring to add conditions to the deals rather than stop them.
- The recent deregulation of the electric power-generating industry.
- Repeal of the Glass-Steagall Act-provisions which were intended to prohibit banks from entering the securities trading and underwriting business.
As for the future of the stock market in 2001 and its impact on the economic health of Wall Street, recent developments may give one pause. In the first half of September 2000, stocks were losing value and market watchers began worrying about an ensuing bear market. The real quandary may be that just as economic fundamentals do not fully explain valuations that are still currently very high, a serious market sell-off may be equally unrelated to underlying economic trends.
Silicon Alley and Tourism
Although its dependence on Wall Street renders New York City vulnerable to an economic downturn, the diversification of the City's economic base continues to progress and to take on added significance. The proliferation of high technology/internet firms along Silicon Alley (notwithstanding recent layoffs), travel/tourism activity, and continued growth of the motion picture industry in New York City all work to help mitigate the City's heavy reliance on the securities industry.
There has been much talk about the financial troubles being experienced by internet firms recently. The so-called "new media" jobs had been cut by a total of about 5,000 during the year 2000; industry sources predict many more cuts in the early part of this year. According to the chief executive of Double Click, Inc., Silicon Alley's largest employer, one-third of all companies will disappear or consolidate, and the worst is yet to come.
In fact, New York's Silicon Alley dot-coms alone have laid off about 3,000 people in the late-summer to early-fall of 2000. The good news is that Silicon Alley is still not big enough to have a significant effect on the City's overall economic health. "As a share of income and employment, it's 2 or 3 percent (of the City total)… That's not bad, but Wall Street accounts for 20 percent of income in the City," according to a New York Federal Reserve Bank economist.
This is not meant to diminish the significance of recently-announced layoffs associated with high-technology firms, which have significant impacts on regions of the U.S. outside New York State. For example, on February 15, 2001, Dell Computer Corp. announced it was laying off 1,700 employees, or four percent of its staff, in its first job cuts ever. Nortel Networks Corp., a telecom-gear maker, also announced on February 15 of this year a plan to cut its staff by 10,000 from the level at the end of last year-in January of this year, Nortel had said it would cut 4,000 jobs in slow-growth areas this year.
According to recent reports, more than 200 dot-com firms nationally have either ceased to exist or filed for bankruptcy, including about two dozen from New York's Silicon Alley. In addition to the abovementioned layoffs in the New York metro area, a 28 percent drop in the amount of investment spent in the fourth quarter of 2000 over the third quarter and a 25 percent drop in the use of Silicon Alley office space is now evident. According to a board member of the New York New Media Association, one can expect that at least half of the 50 or so publicly traded dot-coms once based in New York either will have merged into other firms or disappeared by this time next year (February 2002).
Far more significant than Silicon Alley is the impact of travel/tourism activity on both the City and the State economy. Tourism is New York State's second largest private sector industry, and with attractions like the Adirondacks, Niagara Falls, and New York City, a certain number of people will travel here regardless of how much or how little is spent. There were a record 36.7 million visitors to New York City in 1999, who spent $15.6 billion, paying the salaries of roughly one-quarter million workers in tourism-related jobs. According to estimates from New York City & Company, last year saw a 4.7 percent increase in the number of visitors, setting a new record of 38.4 million total visitors to New York City, who spent $16.7 billion. Their forecast for 2001 calls for a new record-level of total visitors of 39.4 million, who are expected to spend $17.1 billion.
The hotel occupancy rate rose to 84.6 percent in 2000, up from 81.2 percent in 1999-it is forecast to be 83.0 percent in 2001. The New York City hotel room count is expected to have risen by 3,400 last year, and is forecast to rise by another 1,700 this year. In fact, New York City is now the number two tourist destination in the U.S. for domestic visitors (after Orlando, Florida), but is the number one tourist destination for overseas visitors.