Can We Repeat 1994's Soft Landing? Probably Not

Until the past few months, it seemed likely that the economy was in for a repeat performance of 1994's soft landing. While that year was difficult for investors, it set the stage for an extraordinary run for both the economy and for financial markets.

Unfortunately, oil prices became headline news this past summer and threw a monkey wrench into the outlook. In last week's column, I compared the current economic environment to 1990's, the last time energy prices rose so significantly. The comparison suggests that we are in for at least a modest slowdown, though let's hope, not as bad as a decade ago.

But although it's important for an investor to have convictions, it is also crucial to constantly re-evaluate those beliefs against conflicting scenarios. In that spirit, it would make sense to take a look at where we are now vs. the last major tightening cycle by the Fed -- the 1994 round, which provided a textbook-perfect soft landing -- to see what kind of case can be made for the bulls.

In the charts that follow, the red line covers the period from February 1993 to February 1996. This encompasses the 12 months leading up to the Fed's first tightening in February 1994 and the two years following that. The blue line represents the current environment, starting in June 1998 and going through August or September (depending on data availability) of this year.

The first chart shows the behavior of the Fed funds rate during the two periods. After more than a year of a 3% funds rate, the Fed began what would be a yearlong restrictive campaign that saw banks' cost of funds double.

By contrast, the current tightening cycle has been much more modest. The Asian crisis forced the Fed to bring the target rate for the funds rate down to 4.75% in 1998, where it stayed until June 1999. Since then, the rate has gone up by only 1.75% despite the economy being stronger than in 1994. It is now only 0.5% above its prior peak, and is lower when adjusted for inflation.

Unlike 1994, The Fed is Cautious About Raising Rates Fed Fund Rate Increases Are More Moderate This Time Around

Source: St. Louis Federal Reserve Bank

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Truth is, the government is in much better fiscal shape now than it was in 1994 or 1990. Then, the forecasts were for $200 billion-plus deficits "stretching for as far as the eye can see." Now, there is a surplus of more than $200 billion, and people are seriously debating whether all outstanding Treasury debt may be retired. A recent letter to the editor of a New York newspaper expressed surprise that this transformation had occurred before the Boston Red Sox won a World Series. The surplus gives the government more flexibility to deal with a severe slowdown, should one arise.

A Better Balance Sheet A Federal Surplus -- Rather Than a Deficit, Should Ease the Pain

Source: St. Louis FRB

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Paying down the federal debt has also helped to slow the amount of total debt growth, according to the latest flow-of-funds data from the Fed. This slower borrowing pace has helped to keep long-term rates in check. Most mortgages are now traded on the secondary market, and rates are set by the interaction of supply and demand. Mortgage yields rose only 1% during this tightening cycle (compared to 2% in 1994), and have since fallen more than one-half of a percent since they peaked in May.

Homes, Sweet Homes Falling 30-Year Mortgage Rates Could Prevent a Slowdown

Source: St. Louis Fed

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Indeed, mortgage rates could be a key factor in preventing a severe slowdown. During the 1990s, homeowners became much more financially astute, and grew to be more aware of the benefits of refinancing their mortgage when rates fall. By taking advantage of lower mortgage rates, a homeowner with a fixed-rate mortgage receives the equivalent of a permanent monthly tax cut. When rates fell in 1998, the resulting refinancing surge gave a boost to consumer purchases and home improvements that has lasted for nearly two years.

If the economy were to slow significantly, a further decline in mortgage yields of just three-quarters of a percent would make all the mortgages written since summer 1999 (and there are a lot of them) refinanceable. This is perhaps the biggest reason to believe that any slowdown will not be as severe as the one of 1990.

Unfortunately, not all comparisons with 1990 are favorable. Oil prices and overall inflation were fairly steady in 1994, but energy costs have helped push up the CPI now.

Energy Fueling Inflation This Time, Energy Costs Are Pushing The CPI Higher

Source: St. Louis FRB

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Despite the increase in inflation and a tighter Fed, personal consumption has held up very well. Overall spending gains are even more remarkable considering that the economic expansion will be celebrating its 10th birthday in a few months.

But Consumers Haven't Stopped Buying Year-Over-Year %-age Change in Real Personal Consumption

Source: St. Louis FRB

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The good overall numbers, however, mask a worrisome trend. While consumers are still spending, the higher price of energy is causing a shift in the mix of what they are buying. The next chart looks at sales by selected types of retailers over the past year:

Will Oil Burn a Hole In Holiday Spending? %-age Growth of Retail Sales From 8/99 to 8/00

Source: Commerce Dept.

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These data illustrate the big fear for this holiday season -- that rising energy costs could force people to devote a greater proportion of spending to items such as gasoline and heating oil, forcing marginal retailers out and pressuring the remaining ones.

If oil prices remain steady at current levels, the CPI should top out at around 4%. Given the overall healthy state of the economy, this would not be a disaster, but it is a decidedly big negative. If an event such as a harsh winter or a supply disruption sends oil back up again, the odds of us seeing a 1990-type scenario will jump significantly.

From an equity-market standpoint, even a modest slowdown could be ugly. The last chart takes a look at the Nasdaq Composite Index. The left and right scales of the chart are in proportion to each other, 300% from top to bottom. After the Fed finished its 1994 tightening, the stock market took off on a two-year gallop. Perhaps anticipating a similar move, investors (even after a horrible September) have pushed equity prices up even higher this time. An astounding level of margin debt has accompanied this rise, as Herb Greenberg pointed out in Columnist Conversation in RealMoney.com on Monday. An astounding level of margin debt has accompanied this rise.

This Time, Nasdaq Could Be More Vulnerable

Source: NASDAQ

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Further evidence of investors' bullishness can be found in the results of the poll attached to last week's column. I asked readers to give their view on the current economic environment. The results were split almost equally between those who feel that we are in a 1990-type scenario, those who think that the much friendlier 1994 pattern will be replayed and those who are throwing their lot in with that legendary fictional go-go team, Buzz and Batch.

Given that two-thirds of the poll's respondents have bullish views, there would seem to be little room for disappointment. If Buzz and Batch throw in the towel after their inability to walk up their stocks this past quarter-end, those who took Jim Cramer's advice to take something off the table in August might be able to take advantage of some bargains this holiday season.