Wall Street was delighted after Federal Reserve Chairman Alan Greenspan's upbeat assessment of the economy a few weeks ago. He predicted continued moderate growth in the second half and discussed at length the possible inflation benefits of technology-driven gains in productivity. It all sounded like the Fed had put policy on hold for a long time, and that was music to the markets' ears.
But a funny thing happened on the way to the second half. Only a day after the Commerce Dept. reported that second-quarter growth had slowed to 2.2% from the first quarter's rapid 4.9% pace, the first broad reports on the third quarter came rolling in. And they were far stronger than expected, suggesting that the second-quarter slowdown was only temporary. Moreover, contrary to expectations, the Commerce Dept.'s revisions to gross domestic product back 1993 gave no support to the argument that productivity growth in the 1990s is accelerating.
Wall Street's mood turned sour in a flash, especially in the bond market, as worries about inflation and Fed rate hikes began to resurface. After key reports on Aug. 1 from the Labor Dept. and the nation's purchasing managers, any hopes that the 30-year bond yield was headed below 6% anytime soon were dashed. Bonds suffered their worst sell-off in more than a year, pushing the benchmark yield to 6.44%, from 6.29% the day before. The yield has since drifted up to around 6.5%, but good earnings reports have limited the fallout in the stock market.
WALL STREET'S JITTERS will continue as long as the third-quarter data suggest a growth rebound. And so far, the numbers are compelling. The July labor-market report showed that payrolls shot up by 316,000 jobs, more than 80,000 greater than the monthly average in the first half. The unemployment rate fell back to the 24-year low of 4.8% hit in May. Also, new claims for jobless benefits fell sharply at the end of July (chart), suggesting continued job-market strength in August. At first, Wall Street was unfazed by those numbers, because wages held steady and hours worked fell.
But the July survey of the nation's purchasing managers was one hot report too many. The composite index of industrial activity, compiled by the National Association of Purchasing Management, surged to 58.6% last month, from 55.7% in June. It hit the highest level since 1994, with all components looking stronger, including new orders (chart).
Particularly worrisome for the markets were the NAPM's inflation-related indexes. Delivery times slowed markedly, after showing no growing strains in the distribution system in the previous four months, and the index of prices paid is drifting up, with the July reading now the highest in more than two years.
THE MOST CRUCIAL DATA in the rebound forecast, however, are those from consumers, and recent numbers show renewed strength. The second-quarter GDP report said that household spending rose at a paltry 0.8% annual rate, after surging 5.3% in the first quarter, but the monthly data show that spending picked up toward the end of last quarter, after no growth from February through April.
More important, July car sales rebounded strongly, reflecting new incentives and efforts to clear out 1997 models. Sales of domestic and foreign cars and light trucks jumped to a surprisingly sturdy annual rate of 15.4 million, well above the second-quarter average of 14.4 million. And July retail surveys suggest good department store gains.
Another area that promises to provide muscular support to growth in the second half is capital spending. The GDP data revealed that business outlays for buildings and equipment climbed at an annual rate of 15.1%, led by a 20.4% surge in equipment outlays. The surprise is that high-tech equipment was not the main driver. Purchases of more traditional machinery and industrial equipment shot up 23.7%, the largest advance in 3 1/2 years. Companies are responding to strong demand, good profits, and cheap financing. High-tech investment is still rising at a double-digit rate, but it has slowed considerably in recent quarters.
The only possible spoiler in the second-half growth outlook is the first half's rapid pace of inventory growth. Businesses increased their stockpiles by $66.8 billion in the second quarter, after adding $63.7 billion to them in the first quarter (chart). That's the largest two-quarter rise in inventories since 1984. The concern is that second-half production will suffer if companies have to pare excessive stockpiles.
However, the first-half buildup probably has more to do with increasing U.S. demand for imports than with U.S. overproduction. Imports in the first half also rose at the fastest pace since 1984, and excluding oil, foreign goods now account for 30% of U.S. demand for goods. To the extent that any unintended inventory rise is imports, the negative effect of inventory reductions will not fall on U.S. producers.
Moreover, if consumer spending bounces back in the second half, demand will be sufficient to justify further strong inventory growth. In fact, only 10% of the nation's purchasing managers said that July inventory levels were too high, down from 14% in June.
COMBINED WITH PROSPECTS for a strong second half, the failure of the Commerce Dept.'s GDP revisions to show substantially faster economic growth in recent years--and thus a quicker pace of productivity--is stirring up old concerns about how fast the economy can expand without generating inflation. After two major revisions in as many years, the GDP numbers still show that productivity growth in the 1990s is less than the productivity growth in the previous decade.
In fact, what the data show is that profits, which were revised up sharply, are taking an ever-rising share of national income, the highest since 1968. Meanwhile, the share of workers' compensation has decreased to the lowest proportion since 1968. All this suggests that companies are boosting profits more by squeezing labor costs than by lifting productivity.
But as the strike at United Parcel Service Inc. shows, this strategy has its limits. That strike boils down to a company trying to hold down labor costs with cheaper part-time workers who receive limited benefits, vs. employees who want full-time jobs with more pay and better benefits. For that reason, the markets will be closely watching the strike's outcome.
One telltale indicator of labor's new feistiness is the July percentage of unemployed people who voluntarily left their last job. It rose to 12.6%, the most since 1991. To the extent that companies had been shaving costs by exploiting job insecurity, that is another sign that further cost containment will be harder to come by in a strong economy with tight labor markets.