The fast-paced economic growth recorded for the nation during the last two quarters of 2003 will prove sufficient to usher in the long-awaited robust recovery — one that will prove to be sustainable throughout the coming year.

The Department of Commerce reports the nation’s Gross Domestic Product grew a sizzling 8.2 percent during the third quarter of 2003 — the fastest quarterly growth rate since early 1984. But this growth was not driven primarily by consumer spending, which accounted for only 55 percent of the 8.2 percentage points of growth. This is significantly less the long-term average of 66 percent and much less than the nearly 90 percent average for the first seven quarters of the current recovery.

The economic growth rate of the last two quarters of 2003 stands in stark contrast to relatively slow rates of growth recorded over the past two years. To say that the nation’s economic growth since the end of the recession has been slow may be an understatement. More frustrating has been the continued loss of jobs while the nation’s economy grew.

San Diego’s economy has fared better than the nation’s. We did not record job losses and our unemployment rate has hovered around 4.5 percent, two full percentage points below the national rate. Local job growth, however, has declined each year since 1998. Preliminary employment data show virtually no new jobs created during 2003, down from about 10,100 jobs created during 2002. We clearly have moved in sympathy with the nation.

Look for San Diego’s economy to rebound during 2004, posting job gains of 15,000 and a decline in the local unemployment rate, from an average 4.5 percent during 2003 to an average 4.0 percent during 2004.

Passing The Baton

Economists sometimes use a relay race as a metaphor to describe the progress of a recovery, with sectors taking turns moving the economy forward. Thus far, nationally, the consumer sector has been carrying 90 percent of the recovery load, fueled by a combination of tax cuts, mortgage refinancing, home buying, clearance sales by auto dealers and a post-war bounce in consumer confidence. The tax cuts have boosted the level of disposable income by almost 5 percent and consumers have borrowed more than $300 billion in equity from their homes since 2001, spending more than half of the money on consumer products and home improvements. Looking very winded, the consumer sector passed the recovery baton to the business investment sector during the third quarter of 2003.

After a nearly two-year hiatus, spending on capital equipment has finally started to rebound in earnest, jumping 18 percent during the third quarter of 2003. This rapid pace should continue over the next several quarters, climbing two to three times faster than the overall economy. Results from the Institute of Supply Management survey, which tracks the health of the nation’s manufacturing sector, helps clarify the rebound in business investment. The overall index jumped to 62.8 during November 2003, its highest level in 20 years. Every component was 50 or better, the dividing line between improving and deteriorating conditions. The employment index moved higher than 50 for the first time in 37 months. These are strong indicators that suggest the rate of job loss in the manufacturing sector will surely slow, the number of hours worked per week will increase, with a good chance that when the final numbers are crunched they will show employment began to actually increase before the end of 2003. If so, the trend will likely carry over into the first quarter of this year.

Real spending on computers, for example, is expected to have risen at close to a 35 percent annual rate during the fourth quarter of 2003, after rising at a 47 percent rate during the third quarter. As these impressive growth rates are expected to carry over into this year, business spending on computers will likely match or even exceed the peak level recorded before the tech bubble burst.

San Diego’s economy also will likely experience a boost from business investment. Two areas come immediately to mind.

First, Department of Defense expenditures are expected to boost job growth in three important employment clusters: defense manufacturing, telecommunications and biotechnology.

Second, venture capital investments are expected to continue to expand, plowing needed capital into a broad range of firms doing research and development.

Offsetting the boost from business investment in San Diego will be issues unique to California. The state’s budget deficit will come home to roost locally in the form of fewer dollars available for transportation projects, as well as continued weakness and more job losses in state and local government employment.

During 2003, for example, preliminary estimates show that state and local government in San Diego shed 6,000 jobs, by far the largest decline of any employment sector. Similar employment declines are expected this year.

Job Growth Hurdles

The rise in business investment spending nationally has increased the orders for new equipment, placing new demands on the labor market. At the same time, business appears to have reached a limit on getting more out of existing resources. Layoffs have abated; initial claims for unemployment insurance nationwide are below 400,000, the level used as a guideline for helping determine future labor market strength or weakness. However, those focusing solely on headline employment indicators — job growth and the unemployment rate — may miss the real story of the beginnings of a major turn in the labor market. The nation’s labor market has more slack than indicated by the 5.6 percent unemployment reported for November 2003. Labor market slack can take several different forms. For example, not only is the number of unemployed workers high, but there is substantial amount of underemployment. Relatively fewer people than normal are in the labor force and the average workweek of those employed is low by historical standards.

One way to view the labor market recovery is as a series of hurdles. The first hurdle has already been cleared: a shift from job cuts to job increases. The second hurdle is for GDP growth to exceed productivity gains so there is solid demand for work hours. The third hurdle is to fully employ underemployed workers and bring the workweek back to normal levels. The fourth hurdle is to get strong enough job growth to offset the influx of new workers attracted to an improving job market. The final hurdle is to maintain those strong job gains long enough to push the unemployment rate back to the 5 percent full employment target. As this year unfolds, improvements in the labor market can take different paths. Small increases in the workweek and the labor force participation rate, even with low job growth will be signals of substantial future improvements in the labor market.

The long-expected recovery in jobs and investment is under way. History will show that the third quarter of 2003 ended the run of producing more with less, that more than anything else characterized the current recovery.

Is Productivity Good Or Bad?

Strong productivity growth poses something of a dilemma for workers. In the long run, it boosts wages and raises living standards, but in the short run it limits new hiring. In addition, there are two distinct ways to achieve increases in productivity, each having very different effects on job growth.

Up until the third quarter of 2003, gains in productivity during the current economic recovery were achieved by working the existing labor force more efficiently; cutting costs (jobs) to remain competitive at the same time maintaining or increasing output. In the past two years, productivity growth has averaged a robust 5 percent (during the last two quarters of 2003 productivity gains of 7 and 9.4 percent were recorded; huge by historical standards and probably not sustainable). This allowed real economic growth to occur and the unemployment rate to rise. The economy’s growth has been driven by gains in “total factor productivity,” or improvements in business efficiency. Although corporate balance sheets may look better, these types of increases in productivity create problems; at some point real income increases are necessary to sustain a recovery. Consumer spending has been goosed by the temporary factors mentioned above; in turn this higher spending was siphoned out of the income flow and into balance sheet repair and higher corporate savings.

A second way to achieve gains in productivity is for businesses to invest in more plants and equipment; hiring new workers to produce the plants and equipment, and increasing or improving the amount or quality of capital employed by the labor market. Business investments in equipment began in earnest during the third quarter of 2003, and appear to be carrying forward into this year. This investment trend is expected to be the catalyst that keeps the income cycle going this time around, resulting in job gains, higher wages and real income increases. Hiring new workers is probably the most important response. The job market has become the central focus in discussions about the economy. If the national job market does not continue to add new workers at about 150,000 per month, it will damage consumer and business confidence and likely send the economy into a tailspin.

Dissing Inflation

The outlook for inflation in part determines whether one believes economic growth or capacity determines inflation. Part of the difference results from a sense that it does not feel right for inflation to fall as growth picks up, and that, with inflation so low, it has nowhere to go but up. History does not support either of these feel-good claims.One view of expected changes in inflation stems from capacity in the economy; inflation falls when people are unemployed and rises when there is full employment. Another view considers growth-related factors such as commodity prices and money supply as indicators of expected changes in inflation.

While most economists agree that the economy’s rate of growth will pick up and exceed 4 percent during 2004, there is some difference of opinion on the effect on inflation. Rising inflation would mean that the threat of deflation ended and that companies would be able to raise prices for the first time since 2000. Hanging in the balance between these two views is what the Federal Reserve will or will not do to influence interest rates.

The arguments in favor of holding U.S. interest rates low usually involve three observations. First, the output gap is large (difference between potential and actual economic growth); second, inflation is tame and will be held in check by strong productivity growth and the large output gap; third, there is a risk that rising interest rates would derail the economy.

Frozen By A Fedfake

With economic growth expected to exceed the economy’s potential, the countdown to a rise in interest rates fostered by the Federal Reserve has begun. The market is pricing in a better than even odds of a rate hike by mid year. If the Federal Open Market Committee waits any longer it may find it necessary to act in midst of the presidential election campaigns.

Ironically, in an effort to promote “transparency” the Federal Reserve has created confusion among Fed watchers. Through the periodic release of bias statements, the Fed attempts to let financial markets know what it is thinking. Recently, repeated adjustments to the statements appear to have led to more uncertainty, not less.

With fears of deflation rapidly dissipating, the Fed likely will prepare the nation for a hike in the federal funds rate of 50 basis points (0.5 percent) before June, and then let the rate stand through the election season.

Local Housing Prices — Bubble Or Competitive Disadvantage

Housing price appreciation has been strong for a number of years in San Diego, leading some to believe that we have created a bubble that could soon be popped. The price bubble is a concern because the equity gains extracted through sales or refinancing are responsible for the relative strength in consumer spending and the local economy. If a bubble exists, and it bursts, causing home prices to fall, then an important prop of consumption and the local economy would disappear.

In most housing markets, including San Diego’s, home prices tend to increase during good times and flatten during bad times. This leads to few if any declines in nominal home prices (no adjustment for inflation). A possible explanation for this behavior is that housing serves both as and investment and consumption good. When the economy turns sour, homeowners continue to live in the house and delay selling until a more favorable time. A weak housing market likely will experience large declines in the volume of sales, not necessarily large declines in price.

With the local economy rebounding from a sideways 2003, home prices in San Diego are expected to increase during 2004, rising by an average 12 percent. With home prices expected to outpace income, housing will be less affordable and San Diego less competitive as our cost of living continues to spiral upward with no immediate end in sight.

Marney Cox is the chief economist for the San Diego Association of Governments.