The economy will take on a new personality in 1995. It's not by choice. The Federal Reserve is forcing the change with one of the fastest tightenings of monetary policy in postwar history. As a result, the economy's Clint Eastwoods of last year will become this year's Caspar Milquetoasts. And a key determinant in how well the economy holds up will be the performance of 1994's frailest sector--foreign trade.
Higher interest rates will rein in last year's growth leaders, the economy's interest-sensitive sectors. In 1994, spending on consumer durables, business equipment, and housing--a fourth of real gross domestic product--accounted for half of the economy's growth. Not this year.
Slower inventory building also will retard growth, since the need to build up stock levels will not match last year's urgency. In the final three quarters of 1994, inventories rose at the second-fastest rate in more than four decades. Only during the boom times of 1983-84, when the economy was growing at 8%, was there a faster rate of accumulation.
Against that backdrop, foreign trade becomes a central figure in the 1995 outlook. Last year, a widening trade deficit stole nearly a full percentage point from economic growth. This year, trade will go a long way in determining the Federal Reserve's success or failure in bringing this high-flying economy down for a soft landing.
THE PROGNOSIS for trade in 1995 looks considerably better than last year's dismal showing. Of course, it would be hard for it to get much worse.
In November, the trade gap for all goods and services increased to a larger-than-expected $10.5 billion, from $10.1 billion in October. Exports rose 2.2%, but imports jumped 2.5%. The November gap comprised a $15.6 billion deficit in goods and a $5 billion surplus in services. For goods only, the 1994 deficit appears headed for a record.
However, the fourth quarter may well mark the trade gap's turning point for this business cycle, at least when measured in real volume after adjusting for import and export prices. Import growth will slow as the economy cools off, and exports will grow at a double-digit pace, as Europe continues to recover and as growth in the rest of the world remains buoyant. The result: a shrinking trade deficit that will add to economic growth, not subtract from it.
Real exports should accelerate from 1994's 9% pace. Amid major productivity gains, falling unit labor costs, and a weaker dollar against some of our key trading partners, U.S. manufacturers are poised to take advantage of faster global growth. That's especially true in emerging markets, where infrastructure and investment needs fit perfectly with the strong capital-goods profile of U.S. exports.
One growing uncertainty in the export outlook, however, is the fallout from the Mexican crisis. The peso's plunge will cut deeply into Mexican demand for imported goods. Last year, Mexico bought 10% of U.S. goods exports and, at yearend, U.S. shipments headed south of the border had grown about 30% from a year ago, aided by the North American Free Trade Agreement. Taken by itself, a sharp slowdown in Mexican demand will not cut deeply into U.S. exports, but the risk is that the financial turmoil could spread to the rest of Latin America and beyond.
Even north of the border, currency troubles exist. The Canadian dollar has fallen to a nine-year low vs. the U.S. dollar. That means the U.S. currency is exceptionally strong against two of its three largest trading partners, a situation that works against U.S. trade improvement because it encourages imports and discourages exports.
As the case with Canada and certain European countries shows, the global financial markets are making it clear that any nation with high debt and fiscal problems is an increasingly less attractive destination for capital. That will force tighter fiscal policies, higher interest rates, and slower global growth, which could limit U.S. export gains.
THE TROUBLE with trade in 1994, however, was imports. Last year, real imports surged by 15%. Although we now export a record 23% of our goods output, we also import a record 27% of the goods we buy (charts).
However, this increased openness of U.S. trade has a bright side for the outlook. Increasingly, the foreign sector is acting as a stabilizer for U.S. growth during periods of boom and bust. As domestic demand picks up relative to foreign demand, the deteriorating trade balance helps to prevent the economy from overheating. In 1995, just the opposite will occur. A shrinking deficit will buoy the economy, largely because the slowdown in domestic demand is expected to cut import growth by about half.
Moreover, much of last year's inventory buildup was imports. That means that as businesses scale back their need for inventory this year, cutbacks in ordering by retailers and wholesalers will not fall completely on U.S. manufacturers. Foreign producers will share the pain.
IMPROVEMENT in the trade deficit this year will not come fast, though. So far, there is only scant evidence that interest-rate hikes are slowing domestic demand. December housing starts did fall 1%, to an annual rate of 1.53 million, but that followed a 7.6% jump in November. And starts of single-family homes actually rose 2.8%. Permits to begin new construction also increased, although unseasonably mild weather may have boosted activity.
Early-bird reports from retailers on January sales look upbeat. Seasonally adjusted sales at department and chain stores through the third week of the month rose a solid 2.4% from December, says Johnson Redbook Report. Buying from a year ago is up a sturdy 10.4%. That's not surprising, however, given that half of the country was covered in snow and ice this time last year.
Moreover, corporate profits appear to have posted yet another stellar performance in the fourth quarter, according to BUSINESS WEEK's first look. Strong profits will continue to generate the cash flow necessary for businesses to increase their outlays for new equipment.
But as the year wears on, the economy's persona gradually will begin to change. Already, carmakers are sounding a cautionary note. Ford recently announced production cuts in three of its vehicles because of softer demand. And housing, always the first sector to show the effects of rate hikes, is looking weaker.
Mortgage applications to buy a home dropped to a three-year low in mid-January. In addition, a January survey of homebuilders paints an increasingly dim picture. Since July, traffic of potential buyers has all but dried up, says the National Association of Home Builders (chart). And twice as many builders now rate buying conditions as "poor."
As the soft landing begins to gel in response to the Fed's attempt to throttle back domestic demand, think of the improving trade deficit as flight insurance. A slower pace of imports, combined with better export growth, will lessen the chances of a crash landing.
BY JAMES C. COOPER & KATHLEEN MADIGAN