Common economic wisdom holds that once the Iraq conflict is resolved, this recovery will surge ahead. Federal Reserve Chairman Alan Greenspan said as much in his Feb. 11 testimony to Congress when he noted the Fed's "more probable expectation" was that the business sector and economy are poised to grow more rapidly after geopolitical risks are resolved.
The worse, though less probable, expectation is that the economy is still laboring under imbalances that grew out of the late-1990s boom. Remember that it was homegrown cyclical forces, not geopolitical risks, that triggered the 2001 recession. Overcapacity (especially in the tech sector), an inventory overhang, and excessive debt loads were the roots of the downturn.
Talk of these internal drags has been largely swept aside, especially in the wake of September 11 and the scandals at Enron Corp. and WorldCom Inc. But with forecasters banking on a post-Iraq spurt in growth, it's worth examining whether the economy, boosted by consumer demand, has worked through its past excesses.
Analysis by BusinessWeek suggests that significant progress has been made, but the process is far from complete (chart). Steady gains in household spending have been crucial to helping businesses cut down excessive capacity, inventory, and financial burdens. However, manufacturers need more time and stronger demand to mount a long-lasting pickup in output, jobs, and capacity use. Past and future stimulus from Washington will help the spending outlook, but temporary factors--including the weather, $37-a-barrel oil, and jittery consumers--will hold down first-half growth.
FORTUNATELY, the first-quarter economy started off strongly. Consumers crowded stores, if not car dealerships. Factory output jumped, and homebuilders were busy.
The big gain in nonauto retail sales in January was perhaps the most reassuring bit of news, even though consumers face some headwinds in coming months. Total retail buying slipped 0.9% in January because of a 7.5% fall in car and truck purchases, but nonauto sales jumped an impressive 1.3%, their fourth consecutive increase (chart). And housing demand remains solid: Housing starts edged up 0.2% in January, to a 17-year high annual rate of 1.85 million.
February sales and construction won't look as robust. The heightened terrorism alert early in the month probably caused consumers to avoid crowded malls and restaurants, and the blizzard kept many shoppers at home during the long Presidents Day weekend and into the following week, while also idling workers at construction sites.
In addition, higher energy costs during one of the chilliest winters in years are crimping household budgets, while a stagnant job market is raising pessimism. Yet as long as incomes grow faster than inflation, consumers have the wherewithal to keep shopping. And they will get a further financial boost when Washington works out a stimulus plan later in 2003.
BUT A RESILIENT CONSUMER SECTOR won't be a boon to the outlook if businesses are dealing with too many idle factories and excessive inventories. Those overhangs kept the 2002 economy from feeling like a robust recovery. But the industrial sector has been excising its excesses for the past two years, so goods producers should benefit from stronger demand in 2003.
Recall that in 1998, during the boom, the output capacity of U.S. industry was growing 7% annually. That meant production had to rise at least 7% to keep the utilization rate from falling. When demand fell off, output swooned, and operating rates fell to levels not plumbed since the 1981-82 recession.
Now, industry is increasing capacity by just 1% per year, according to the Fed's latest data. With so little new capacity coming on line, operating rates are above their lows of a year ago. The 0.7% rise in January industrial production caused the industrial operating rate to increase by a half-percentage point, to 75.7%. That's still well below the 82% mark typical for a busy industrial sector, and at the current rate of capacity growth, output gains averaging 0.3% per month would lift the utilization rate to only 78% by yearend.
The progress in paring the capacity glut in high-tech industries has been especially noteworthy. In 2000, the capacity of tech-equipment producers, including computers, peripherals, communications equipment, and semiconductors, was growing in excess of 40% annually. For the past 12 months, the growth rate now stands at only 8% (chart).
THE PROBLEM HERE is that tech-industry output, while having picked up over the past year, still lags behind the pace of capacity. Operating rates in high-tech industries stopped falling about a year ago, but at just under 62% in January, they remain near a record low.
However, keep in mind that the tech glut is concentrated disproportionately in communications equipment. After growing at more than 25% per year in early 2000, telecom capacity is no longer increasing. But output of telecom equipment is down 12.6% from a year ago. That means the operating rate for telecom producers, which had plunged from 85% to 49% over the past two years, has room to drop even further.
Other tech-equipment makers are in better shape. Output of computers and office equipment is substantially outpacing capacity growth, and the operating rate has recovered from a low of 66% in September, 2001, to 78% this January. Utilization rates at semiconductor plants are up from a low of 61% early last year, but at just under 66% in January they remain far below the near-100% rates seen in the spring of 2000.
Capacity isn't the only glut companies have pared down. They've also trimmed inventories sharply. The five-quarter inventory liquidation that ended in early 2002 was the largest on record. Since then, businesses have built up their stockpiles cautiously. In December, the ratio of inventories to sales for all businesses was below its long-run trend, suggesting that stockpiles are lean and that businesses are ready to increase their stocks at the first sign of stronger demand.
Inventories in the tech sector, while in much better shape than they were a year ago, remain a bit high compared with current sales levels. That means that many tech-equipment producers, especially makers of telecom gear, are still adjusting their stockpiles.
On balance, though, most businesses, including many tech companies, have made great strides in cutting through the excesses of the late '90s. However, the remnants of those overhangs remain drags on the economy. As a result, any post-Iraq recovery is bound to feel better than what we have now in terms of output and hiring. But the upturn may not be the explosive affair that many company executives, workers, and investors are hoping for.
By James C. Cooper & Kathleen Madigan