Housing and autos are only specks in the gross national product. Their far-reaching impact, however, on the demand for everything from light fixtures to lug nuts wields a powerful influence on the business cycle. Right now, they are saying that the recovery is struggling.
Housing starts fell in September. And car buying, after weakening in August and September, crashed in early October. The consequence: Industrial output is slowing down. If consumer demand for housing and autos is flagging, there isn't much else on the horizon to generate production pep this quarter. And so far, manufacturing has been the recovery's main engine.
Someone had better remind the bond market of all this. Until lately, the fragile state of the recovery -- and its implications for lower inflation and interest rates--had been the major influence in the bond rally that began in mid-July. Yields on 30-year Treasury bonds fell from 8.5% to 7.8% in early October. But since then, the market has been pelted by worries that are, at least for now, overshadowing the still-uncertain outlook for the economy.
A combination of inflation jitters, worries about tax cuts (page 28 34 ), the Federal Reserve's failure to cut short-term rates, and a rush of debt issues from Japan lifted the 30-year yield back to nearly 8.1% on Oct. 22, prompting speculation that the bond rally may be over.
The bond market is particularly upset by the prospect of tax cuts. A tax package generates concerns about inflation and opens the possibility of an even greater flood of Treasury paper, if the cuts further widen the federal deficit.
The budget gap is already expected by most economists to zoom to at least $350 billion in fiscal year 1992. If the consensus expectation for GNP growth in 1992 is on the mark, the deficit is already on track to approach the record of 6.3% of GNP set in 1983 (chart).
THE BOND RALLY MAY NOT BE OVER
The bond market may be overreacting, however. Traders got bent out of shape on Oct. 17, when the government reported that the consumer price index rose an unexpectedly large 0.4% in September. The core CPI, which excludes volatile swings in food and energy--rose by a disquieting 0.4% for the fourth consecutive month. But that is not indicative of the CPI's true trend.Prices for medical care, tobacco products, education, and entertainment--only about 15% of the CPI--rose rapidly in September, but not because of economic strength. Medical costs are a structural problem, new taxes are boosting tobacco prices, education costs are rising because of troubled state and local governments, and entertainment prices posted a one-time jump.
Taking the longer view, inflation--both overall and the core rate--continues to moderate (chart). Core inflation has fallen from 5.7% in February to 4.5% in September. As in past business cycles, the progress should continue well into the recovery, particularly since the upturn is laboring.
Bond traders may also be misreading the Fed. The downbeat message from housing and autos says that the central bank is likely to find the opportunity to shave another quarter-point off the federal funds rate, now at 5 1/4%, sooner rather than later. Indeed, the Oct. 23 report from each of the Fed's 12 district banks is not encouraging. It said that the economy in September and early October was "weak or growing slowly."
HOUSING MAY DECIDE TO HIBERNATE
The bond market is likely to regain its focus in coming months, as evidence of the recovery's battle to survive becomes clearer. Housing starts in September fell for the first time since March, dropping by 2.2%, to an annual rate of 1.03 million (chart, next page). Building permits, an indicator of future construction, rose 2.7%, recovering about half of their 5.2% decline in August. Starts of both single-family units and apartment buildings fell, and only the South posted a gain.
The slip in housing starts is somewhat surprising, because it came while mortgage rates were falling. The lift from lower rates, however, is being offset by factors that are a drain on housing demand. Fewer new households are being created, for example. And affordability remains a problem for some consumers. Builders, meanwhile, seem to have been hit hard by the credit crunch.
In addition, consumers continue to worry about the future. According to preliminary results, the University of Michigan's index of consumer sentiment dropped in October to its lowest level since the gulf war.
Fewer new jobs and smaller pay raises are causing headaches for consumers, who are already strapped for cash. Personal wealth--households' assets minus their financial liabilities--fell in 1990, according to the Federal Reserve. And it most likely will drop again this year. That means fewer people are willing or able to carry the huge debt burden that comes with a new house.
Right now, the end to falling interest rates adds even more risk that the housing recovery could stall out. The average fixed rate on a 30-year mortgage rose slightly in mid-October, to 8.9% from 8.89% in the week before, according to HSH Associates. That was the first increase in four months.
Meanwhile, the auto rebound is anything but turbocharged. Like housing, the recovery in car production has been steady but subdued. Auto makers have kept production modest, making fewer cars than have been sold this year (chart). That has kept inventory levels low.
But can Detroit continue that success in the fourth quarter? Auto makers plan to produce at an annual rate of about 6.1 million cars this quarter, but even that may be too many. Only 6.2 million domestically made new cars were sold in the middle 10 days of October, after an awful 5.5 million pace earlier in the month. October car output may outpace sales for the first time in two years.
FACTORIES WRESTLE WITH WEAK DEMAND
If cars and housing lose ground this quarter, the spillover effects will be especially acute in the industrial sector. Already, the factory recovery is flagging. Industrial output rose by only 0.1% in September, and after revisions, August production was flat, instead of the 0.3% gain originally reported for that month. So although third-quarter
industrial production grew at a 6% annual rate, that healthy advance reflected strength in June and July, not in the later months.
A large weather-related drop in energy demand dragged down the September output data. The decline in utility use also caused the industrial operating rate to fall to 79.7%, down slightly from 79.8% in August.
Manufacturers lifted their output by a healthy 0.5% in September, as auto output jumped 8%. But excluding autos, manufacturing output was up a mere 0.1%, as many producers struggled with lackluster demand.
Makers of business equipment, excluding autos, saw output gains slow during the summer. Capital-goods makers may not be able to shake off their malaise in the fourth quarter. The rise in long-term interest rates will hurt domestic demand, and foreign buyers are showing signs of fatigue.
Indeed, foreign trade was a drag on third-quarter GNP. In August, the merchandise trade deficit rose to $6.8 billion, up from $5.9 billion in July. A 3% drop in exports, to $34.2 billion, along with a smaller 0.6% fall in imports, to $40.9 billion, caused the gap to widen. After taking price changes into account, the trade deficit so far in the third quarter is 50% bigger than it was in the second quarter.
The rise in imports may also be a drag this quarter if a significant amount of those foreign goods landed in inventories. If so, then the inventory rebuilding that is expected for the fourth quarter would be less of a boost for domestic producers.
That's another reason to worry about the upturn in manufacturing, which is already wrestling with high interest rates and sluggish demand for autos and housing. The real danger is that, if the factory rebound goes flat, the entire recovery will be in serious trouble.