U.S.: When Bad Quarters Happen To Good Economies

Growth stalled. But Greenspan sees inflation, not weakness, as the No.1 risk

In a word, the economy's performance so far this year has been "impressive." So said Federal Reserve Chairman Alan Greenspan in his semiannual testimony on monetary policy before Congress. What Greenspan also acknowledged, however, is that this impressive expansion hit a speed bump in the second quarter. As the chairman succinctly put it: "Growth of U.S. output appears to have slowed sharply."

How sharply won't be known until the Commerce Dept. releases its gross domestic product report on July 31. But the monthly data suggest that an abrupt slowdown in inventory building and another huge widening in the foreign trade deficit deducted some five percentage points from GDP growth, offsetting substantial gains in consumer spending, housing, and business investment. As a result, real GDP probably did not grow at all last quarter. Some economists even think real GDP shrank, with softness expected in the third quarter as well.

But the second quarter's weakness may not signal a prolonged slowdown. The economy continues to enjoy solid job and income growth, accommodative credit conditions, a booming stock market, and low inflation. In fact, the Fed's own forecast for 1998 implies that real GDP growth will rebound to more than 3% in the second half (table) before slowing in 1999.

Moreover, the GDP release will contain benchmark revisions to the historical data, which may affect the outlook. For example, the numbers now say that first-quarter inventory levels grew by an unprecedented $105.7 billion--eclipsing the previous record by a huge $18 billion. If inventory growth is revised lower, then the inventory adjustment in the second quarter and beyond would be less of a drag on growth. Greenspan himself said that, without knowing the revisions, assessments of a negative second quarter are "conjectural."

NONETHELESS, EVEN IF THE DRAG from inventories is smaller than expected, real GDP still struggled to creep into the plus column. The chief reason was the broadening chasm between exports and imports.

The May trade deficit for goods and services widened to a record $15.7 billion, up from $14.3 billion in April. Both numbers show a sharp expansion from the first-quarter average of $11.6 billion, which was up from $9.5 billion in the fourth quarter. Taken by itself, the second-quarter increase in the trade gap appears to have subtracted 2 1/2-to-3 percentage points from the quarter's GDP growth.

A dropoff in exports to Asia has been the primary influence. Exports fell 1.3% in May, after posting a 2.4% loss in April. Since July of last year, when the Asian crisis began, U.S. shipments of goods to all Pacific Rim countries have dropped by $3.6 billion, using Commerce Dept. data that have been seasonally adjusted by BUSINESS WEEK. That decline more than accounts for the $2.7 billion falloff in overall exports of goods and services during that time.

MEANWHILE, IMPORTS from most everywhere continue to arrive at a rapid clip, sucked in by strong U.S. demand. Foreign goods and services increased 0.5% in May, and since last July they have risen by $4.2 billion. And because of falling import prices, the rise in the actual volume of imports has been much larger than the dollar figures suggest.

Erosion in the trade deficit reflects more, however, than just weak Asian demand. It appears that the three-year rise in the trade-weighted dollar is finally crimping the competitiveness of U.S. companies. Indeed, exports of goods to destinations other than Asia have also fallen off this year, especially shipments to Europe--and European growth is generally picking up. In the past six months, non-Asian countries have accounted for more than half of the widening in the merchandise trade deficit (chart).

The good news is that in April and May, the deterioration in the trade deficit with Asia slowed. The bad news for the second half: Even as the export drag starts to lift, Asia is only now beginning to send more imports this way. Moreover, the strong dollar will crimp all U.S. exports and keep imports washing ashore. In fact, by yearend, the U.S. current account deficit, which includes trade and certain financial transactions, will probably climb above 3%, a level that often has preceded a tumble in a country's exchange rate.

NEEDLESS TO SAY, the swings in trade and inventory growth have hit goods producers the hardest. In fact, Greenspan's remark referred to a possible sharp slowdown in "output" last quarter, not in demand.

Industrial production fell 0.6% in June, as did factory output alone. True, the General Motors Corp. strike caused an 11% drop in vehicle production. But even excluding autos, factories eked out just a 0.1% output gain in June. Total factory output grew at an annual rate of 1.7% last quarter, the smallest gain in more than two years, as manufacturers felt the squeeze from weak foreign demand and slower stockpiling.

Looking ahead, the GM strike is subtracting even more from July output, and it may well drag on through the entire quarter. When the strike is over, however, auto output will bounce back sharply.

The manufacturers that did do well in the second quarter were the ones that cater to domestic customers: Appliance, home-electronics, and business-equipment manufacturers all increased production handily in response to solid demand in the U.S. last quarter. Real consumer spending increased about 5%--an amazing gain considering that it follows a 6% surge in the first quarter. And shipments of capital goods suggest that business outlays for equipment increased again.

Another plus for GDP growth was homebuilding. Housing's ongoing strength is somewhat surprising since the mild winter had boosted home construction to record levels in the winter. That led to expectations of a weak second quarter. Instead, residential construction probably continued to grow last quarter after soaring at a 16.9% annual rate in the first.

In addition, housing starts ended the second quarter on a strong note: They increased 5.6% in June, to an annual rate of 1.615 million. And builders are quite optimistic. The Housing Market Index--a compilation of readings on current sales, expectations, and buyer traffic--hit another record in July, rising to 72% from June's 71% (chart).

Healthy consumer demand may be buoying builders' spirits, but it's also clouding the view of the Fed Chairman. Despite the economy's weak second quarter, Greenspan made it clear that the Federal Reserve remains vigilant against overheated demand forcing up inflation. And in his view, the risks remain greater for accelerating inflation than for any protracted weakness in the economy.

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