FULL-TILT FACTORIES AREN'T AS SCARY AS THEY LOOK
If the U.S. economy is slowing down in the second half, it looks as if someone forgot to tell manufacturers. In August, production soared, output in previous months was revised up considerably, and factories used their capacity at the highest rate in more than five years, a level often associated with production bottlenecks and price pressures.
The inflation-jittery bond market nearly jumped out of its skin when it saw the news on Sept. 16 . Bond prices plummeted, sending the yield on the benchmark 30-year Treasury bond to 7.8%, the highest since June, 1992. To some, the data suggested that the economy might even be speeding up, a scenario that would fuel inflation and force the Federal Reserve to tighten policy further, maybe even more than generally expected.
However, a closer look at the factory sector reveals a less alarming picture. First of all, the unusual pattern of auto production this year suggests that overall output is overstated. Also, the Fed's capacity numbers are at odds with the ongoing surge in business investment, which could mean that operating rates are also exaggerated.
In addition, slower inventory growth in the third quarter is sure to be a big drag on real gross domestic product. Housing has gone flat. Consumers look winded. And capital spending, while still strong, is also set to slow. That's not to mention the continuing deterioration in the U.S. trade deficit, as seen in the July data. All this doesn't suggest a sick economy, just a slower one.
The top-line output numbers in August showed that industrial production in the nation's factories, utilities, and mines rose 0.7%, with manufacturing output up 1%. Production from April to July, originally said to have grown 1%, is now shown to have risen 1.5%.
However, a bounceback in auto production, as Detroit revved up assembly lines following its summer shutdown for retooling, accounted for half of the August advance in both total industrial production and manufacturing output. That's not to say cars don't count. They do. But Detroit's shutdown and catchup are distorting the economy's underlying pattern.
For example, so far in the third quarter, factory production shows no sign of slowing from its second-quarter pace. But excluding motor vehicles, the remaining 94% of factory output is slowing sharply (chart). Indeed, not counting August's 11.7% surge in auto production, output of consumer goods other than autos fell 0.1% in the month, led by declines in appliances and other durable goods.
Detroit also helped to push up the industrial operating rate in August to 84.7%, and to 84.3% in manufacturing. Industry hasn't used that much of its capacity since 1989, when the rate peaked at 84.8% and scattered price pressures started to crop up. Several industries are running flat out (table).
This time, though, the accuracy of the Fed's measure is in doubt. The operating rate is the ratio of what industry is producing to what it is capable of producing. Economists at Merrill Lynch & Co., for example, argue that the Fed is understating the amount of available capacity, which would cause the operating rate to be overstated.
During the past year, they say, the Fed's numbers show that available capacity is up 2.8%, even though equipment investment has surged 15%, suggesting a faster increase in capacity that would result in a lower utilization rate. The Fed will revise its capacity data in late November, and operating rates are likely to be redrawn at least slightly lower.
Equipment investment's strength is clear in the industrial-production data. Output of business equipment rose a strong 1.6% after an equally sturdy gain of 1.3% in July. Equipment output is up 13.2% from a year ago, about twice the pace of overall industrial production.
However, the quarterly pattern of capital-spending plans indicates that the investment boom will be a bit less resounding in coming months. However, for capital-goods producers, it might not seem that way, as export demand takes up some of the slack. The problem, though, is that American businesses continue to get an increasing share of their new equipment from abroad, and that's not helping the U.S. trade deficit.
Indeed, capital goods are the Cliffs Notes of the whole foreign trade story. Overall, domestic demand has sucked in imports at a faster pace than exports have been growing (chart). The good news for the outlook is that this disparity will end.
The bad news is that the third quarter may not see the benefits. The trade deficit for all goods and services widened unexpectedly in July, rising to $11 billion from $9 billion in June. The dollar tanked on the bad surprise, taking the U.S. stock and bond markets with it.
The sharp erosion means foreign trade started the third quarter far below its average for the second quarter, when a deteriorating trade performance robbed almost one percentage point from GDP growth.
For goods alone, the trade gap jumped to $15.7 billion in July from $14 billion in June. Using comparable data calculated on a customs-value basis, the merchandise trade deficit in July was the largest since 1985.
Goods exports fell 4% in July, led by a drop in aircraft. Despite this, foreign shipments are doing quite well. They've grown 10.6% in the 12 months ended in July.
One export area that is struggling is agricultural products. They're down 9.6% in the first seven months of 1994. A bad 1993 harvest, a bankrupt Russia, and greater competition from South America, China, and South Africa have eaten away at what was a major export category for the U.S.
Looking ahead, U.S. exporters will benefit from the stronger global growth expected in 1995. With Europe largely out of recession, demand for U.S.-made goods will pick up there. And the robust economies in Southeast Asia and Latin America will also power exports.
Stronger growth abroad will brighten the trade outlook for exports, while modest growth at home should slow the tide of imports. True, imports were flat in July, but they have soared 14.8% in the past year. Slower import growth by the fourth quarter will be one of the byproducts of the Fed-engineered slowdown in domestic demand.
The effect of higher interest rates has already shown up in housing activity. Although housing starts rose 2.1% in August, to an annual rate of 1.44 million, all of the strength was in apartment construction. Starts of single-family homes fell 2.7%, to 1.17 million (chart). So far in the third quarter, total starts are below their second-quarter level, and they are down 3.3% from their recent peak in the fourth quarter of 1993.
Moreover, higher rates, especially for adjustable-rate mortgages, have some homeowners struggling. The Mortgage Bankers Assn. reports that second-quarter mortgage delinquencies rose for the second consecutive quarter. The uptick suggests that homeownership is becoming a burden for an increasing number of households.
With less homebuilding, demand for home-related goods will wane. The biggest losers will be appliances, carpeting, and building materials--products that go into a home as it is being constructed. Production of consumer durable goods, excluding cars, fell 0.6% in August.
With exports expected to gain steam next year and business investment in equipment likely to grow faster than the overall GDP, controlling consumer spending will remain the primary way policymakers slow down this economy. Their task is well under way: The hot data of August in the factory sector notwithstanding, the U.S. has shifted down to a much cooler pace in the second half.JAMES C. COOPER AND KATHLEEN MADIGAN