THE ECONOMIC FORECAST IS A LOT BALMIER THAN THE WEATHER
April may be the cruelest month, but July is turning out to be torturous for most of the U.S. Heavy rains have caused flooding along the Mississippi River, while record high temperatures have sizzled the Eastern states like so many rashers of bacon.
But while the lethal weather has caused enormous suffering, its economic impact will be small and temporary. The U.S. economy still seems poised for better growth in the second half of the year, following a disappointing first half. And in particular, excess capacity and surplus labor both at home and abroad mean the outlook for inflation remains very positive.
To be sure, the rain and heat of the past few weeks will buffet the economic data for July and perhaps for August as well. Retail sales could take a hit, after posting a good gain in June. That's also true for July housing starts and manufacturing output. In addition to plant shutdowns, holes in the transportation system will also stymie factory activity, since trains and barges stranded along the Mississippi cannot move goods.
But despite the weather-related supply disruptions, consumer inflation should remain quiescent in coming months (chart). That's partly because the cost of grain contributes so little to the final price of processed foods. And if the Midwest rains diminish, as is now forecast, cargo should begin moving soon, avoiding any drawn-out shortages or production bottlenecks.
The chief reason, however, why inflation will stay down is the lack of sustainable price pressures. That much seems clear from the government's exceptionally tame reports on producer and consumer prices in June. Both these reports, combined with the becalmed May price indexes, give further confirmation that the early-year inflation scare was unfounded.
The consumer price index did not rise at all in June, following a slight gain of 0.1% in May. Prices declined for food, especially fruits and vegetables, along with gasoline, clothing, tobacco, and home furnishings. After starting the first four months of 1993 at an annual rate of 4.3%, inflation for the first half has now cooled off to just 3.1%. The same pattern is true for core inflation, which excludes energy and food prices. The core CPI rose by a scant 0.1% in June, after having posted a modest 0.2% increase in May.
Inflation's subdued behavior has not gone unnoticed in the bond market. After the release of the CPI data on July 14, the yield on 30-year Treasury bonds closed at a record low of 6.56%. Long-term rates have been falling since late May, and the decline may not be over. With 1993 inflation now looking closer to 3% than 4%, many market players are not ruling out a move to below 6.5%.
As early-year inflation fears unwind, in combination with the recent tepid performance of the economy, the Federal Reserve is very likely to rescind its bias toward tighter monetary policy adopted at its May 18 meeting. Judging by the recently released minutes of that session, the Fed clearly recognized that factors such as excess capacity, high unemployment, and global competition argue that the winter price jumps were anomalies.
In addition, the central bank is also aware that problems in the way the government seasonally adjusts the data may have contributed to the large price rises reported earlier.
Even after seasonal adjustment, BUSINESS WEEK has found that the total consumer price index consistently overstates price increases in the first and fourth quarters of the year. Most of the exaggeration comes from uncaptured seasonal trends in food and energy costs. Also, adjustment problems in apparel prices cause the overstatement of the core inflation rate in the first quarter. When the CPI data are readjusted, inflation looks tamer.
Clearly, there are no price pressures building among goods producers or commodity suppliers that will feed consumer inflation (chart). The producer price index for finished goods dropped by 0.3% in June, after no gain in May. The core PPI fell 0.1% after rising only 0.2% in May. Falling prices for food, tobacco, and energy led the overall June decline, which pushed the 12-month inflation rate for producer prices down to 1.5%, sharply below the 2.4% clip in April.
Moreover, the recent runup in commodity prices does not reflect any deterioration in the bright inflation outlook. It stems from the flood-related jump in grain prices and a rise in gold prices largely unrelated to inflation expectations. Elsewhere, prices for industrial commodities, the best gauges of emerging price pressures worldwide, are going nowhere.
Indeed, the forces restraining U.S. inflation are not just domestic. They're global. Inflation in the seven largest industrial economies is running at less than 3%, and it will slide even lower, because of slow growth or outright recessions hitting the major nations.
International economists at Merrill Lynch & Co. say the Group of Seven currently has a combined gap between actual and potential gross domestic product of 4%. They forecast that the gap will widen to 5% by yearend, implying a growing excess of labor and industrial capacity, virtually precluding any buildup of demand- or cost-related price pressures.
Another reason inflation should stay low is the resistance that businesses face in marking up prices. Consumers have become more price-conscious. And even though households are likely to increase spending by a healthy pace of 21 2% or 3% in the second half, shoppers will continue to pass up expensive goodies.
Consumers' willingness to spend was apparent in the retail sales data for June (chart). Retail sales rose by 0.4% last month, and the April and May increases were both revised upward. Those gains--along with declines in goods prices in May and June--mean that real retail volume grew at an annual rate of 5.2% in the past quarter, following a 1.1% drop in the first quarter.
Big sales increases were posted last quarter at car dealers and at furniture and department stores. And readings for early July look favorable, judging by reports from retailers and by car and truck sales.
Why are consumers spending again? Better-looking employment prospects are one reason. The U.S. economy has already generated nearly 1 million new payroll slots this year, and that has lifted income growth. Moreover, jobless claims are trending lower, while the Conference Board's index of help-wanted advertising rose in May to its highest level in 21 2 years.
Another factor sprucing up the outlook for consumer spending is the resurgence in borrowing. After paring down debt for two years, consumers are using credit cards and taking out bank loans again (chart). In May, installment debt dipped for the first time in nine months, falling $802 million. But that small decline followed large gains of $3 billion in both March and April.
Consumers may be borrowing again because they have tidied up their balance sheets considerably. Financial assets of households have been growing at more than twice the pace of liabilities for two years. And the stronger housing market means that the major asset of most consumers--their house--is worth more, even as lower interest rates have helped homeowners refinance mortgages and cut their monthly payments.
Also, the borrowing moratorium of the early 1990s has reduced the monthly payments on other IOUs. Household debt service stands at about 16% of disposable income now, down from 18.5% in mid-1990.
Financially stronger consumers will help to lift economic growth in the second half, even as the Fed maintains its price watch. Like a meteorologist scanning the skies for approaching storms, the central bank will remain alert to any signs of inflation. Despite July's floods and soaring mercury, though, there just aren't any price pressures in the forecast.JAMES C. COOPER AND KATHLEEN MADIGAN