Beneath all the ups and downs in the data, one fact always stands clear: The business cycle turns on policy. The current mix of actions by the Federal Reserve, the White House, Congress, and state legislatures tells a lot about the outlook for the U. S. economy. In particular, it presents a powerful reason why a recovery is likely to arrive later rather than sooner.
Policy is the economy's fundamental influence, because it sets the tone for domestic demand. Right now, spending by consumers and businesses is at the core of the economy's weakness. And demand is getting far less help from Washington than in past recessions.
That's one reason why the latest numbers show that manufacturing--whose health is crucial to a recovery--continues to languish amid a severe drop-off in new orders. Slower growth in exports threatens to sap the factory sector's vitality even more.
UNCLE SAM WANTS MORE
Fiscal policy is actually fueling the recession. Clearly, tax and spending programs rarely have provided much help during a downturn, since Washington has usually acted too late to do anything but reinforce past recoveries. This time, however, in an effort to close a gaping federal deficit, Washington's tax hikes are eating into incomes and helping to set a new standard for economic restraint during a recession.
Then add in the state and local problem. Those budgets were already in deficit by a record amount going into the recession. Now, they are getting worse. Some 30 states are swimming in red ink, nearly 40 have already raised taxes, and many are slashing services.
All together, the tax bite on incomes is high and rising at a time when it usually falls. Household taxes--including federal, state, local, and Social Security payments--as a percentage of personal income have averaged 20.1% since the recession began. That's the largest three-quarter burden on record, and it does not include property or sales taxes. The tax bite fell in all previous downturns in the postwar era, but this time, it continues to rise (chart).
With fiscal policy so out of touch with the economy's needs, the job of putting together a recovery falls fully on the shoulders of the Federal Reserve. The Fed's task is made even more difficult by the unprecedented drain on incomes from higher taxes. So far, the Fed has made barely any progress toward getting the economy's credit-sensitive sectors moving again.
After rising in February, housing indicators headed south again in March, and April car sales remained disappointing. In the month's first two 10-day periods, sales of domestically made cars averaged 5.6 million at an annual rate, down from a 6.2 million pace in March.
Part of the Fed's problem is the unwillingness of bankers to lend because of stricter regulation and weak profits. As a result, lending rates are coming down a lot slower than banks' cost of funds. Since last October, the central bank has cut the cost of federal funds, or interbank borrowings, from 8 1/4% to 6%. However, the prime rate, which determines interest costs for many consumer loans, has come down only a point, to 9%. That's the widest spread between those two rates in nine years.
In addition, the Fed's easing of short-term rates has done little to cut the long-term rates so important to mortgage lending. Long rates have remained stubbornly high, primarily because of fears in the bond market that an imminent recovery will thwart progress on inflation.
Moreover, the Fed is trying to encourage consumers to borrow at a time when their real incomes are falling and when their debts are already high. Until monetary policy can spur demand in the credit-driven sectors, the economy--and manufacturing in particular--faces a tough road.
FACTORIES MAY FACE FURTHER CUTBACKS
To be sure, factories are desperately seeking demand. The reasons: Weaker economies abroad have stalled the growth of U. S. exports. And here at home, consumers and businesses just aren't spending.
The latest report from durable-goods manufacturers makes this painfully clear: Their new orders plunged 6.2% in March, to an annual rate of $110.3 billion. That was the lowest level in 3 1/2 years (chart).
The drop was far worse than even the most pessimistic expectation, and it came after three declines in the previous four months. Transportation equipment led the March drop-off, but the weakness was broad.
Shipments of durable goods also continued to unravel. They dropped 2.4% in March, to $114.7 billion, the fifth decline in a row. That surely places additional pressure on manufacturers to trim their inventories and could mean that more cuts in output and jobs are on the way.
Sales of nondefense capital goods, in particular, were hammered in the first quarter as many businesses apparently put their capital-spending plans on hold. Such shipments fell at a 6.8% annual rate last quarter, suggesting that equipment spending was very weak. And March's 10.3% plunge in new orders for capital equipment paints a dim outlook for future spending.
The lack of new demand means that manufacturers are depleting their order backlog. Unfilled orders fell 0.9% in March, after no change in the prior two months. Excluding aircraft, where demand is strong, the backlog is down 6.5% from a year ago. That's another sign that more cuts in factory payrolls and output lie ahead.
The dismal state of manufacturing was underscored by the latest survey on business conditions taken by the National Association of Business Economists. Economists working in goods-producing industries said that first-quarter demand growth at their companies fell to the second-lowest rate posted since the last recession, eclipsed only by a steep decline in the fourth quarter.
EXPORTS WON'T COME TO THE RESCUE
The NABE survey also reported that exports showed new signs of life in March. If those reports are right, it will be good news for manufacturers. However, exports face some problems, and they are largely outside the reach of policymakers.
In February, merchandise exports dropped 2.4%, to $33.5 billion. That was the third decline in the past four months. Slowing economies in many of America's trading partners has cut world demand for U. S. goods. Growth in exports to Britain, Japan, Mexico, and Brazil has weakened considerably during the past year.
Over the past 12 months, exports have risen 6.1%, down by almost half from the 11.1% pace in the year before that. Despite this slowdown, foreign demand remains a positive force in the U. S. economy, and it provides a cushion for companies that ship abroad. However, merchandise exports account for only 10% of the real gross national product. That means foreign trade is unlikely to catapult this economy out of recession.
Moreover, a stronger dollar means exporters will soon face a tougher time maintaining their competitiveness. Since mid-February, the dollar has climbed 7.1% against the currencies of our major trading partners (chart).
A change in the dollar's value takes about six to nine months to affect exports. So as U. S. exporters find it difficult to keep their price edge, foreign shipments in the second half may suffer. And the increasing prospects of a global recession could hurt even more.
Meanwhile, the downturn at home has hit foreign producers. Imports slid 6.4% in February, to $38.8 billion. This large drop helped to narrow the month's trade deficit from $7.2 billion in January to $5.3 billion in February, the smallest in seven years.
Lower oil imports contributed greatly to the February drop because of declines in price and volume. But other import categories have been declining since October, when imports hit a record high. In particular, the drop in consumer spending has caused sharp declines in imports of cars and other consumer goods.
To pull domestic demand out of its funk, the Fed may well have to cut interest rates another notch or two. But once a recovery is finally under way, another important policy consideration will come into play. That is, the Fed is the one policy agency that does not want a brisk upturn for fear that strong growth will fuel inflation. As long as monetary policy remains the economy's only source of stimulus, the Fed may well get its way.