Recovery? Not Until Consumers Snap Out Of It

There's a new "R" word floating around: Not recession, but recovery. The stock market thinks it sees one in easy money, low inflation, lean inventories, and Mideast peace. Clearly, those are important elements of a turnaround, but unless people start spending, the market's vision will turn out to be a mirage.

Flagging demand, led by the dropoff in consumer buying, dragged the economy into recession, and getting consumers and businesses to spend again may take longer than the market thinks. The troubles run deep. Consumers still face fading incomes, heavy debts, and low savings. Peace in the gulf won't change that. Many companies are also saddled with debt, and profits are too poor for executives to think about boosting outlays for plants and equipment.

Right now, the financial problems of consumers are offsetting the Federal Reserve Board's cuts in interest rates, and increasingly stingy banks are just making matters worse. New homes aren't selling, so builders aren't building. Car buying is at recession levels, and sales of most other goods are faring just as poorly. As usual, manufacturing is getting hit especially hard.


That's not what many economists were predicting a few months ago. They expected the industrial side of the economy to weather this recession in relatively good shape. Exports now take a record 20% of factory output. Factories have inventories and debt under control. And solid productivity gains have helped cut unit labor costs and boost profitability.

All this certainly puts factories in a good position to take advantage of the recovery when it arrives. But until consumer demand, capital spending, and homebuilding get back on track, manufacturing--and the economy--will not be able to make much headway.

It is true that industrial activity is on a roll, but the direction is downhill. In January, the combined output of the nation's mines, utilities, and factories fell by 0.5%, the fourth consecutive decline (chart). And the December data were revised sharply lower, to show a 1.1% decline in output instead of the 0.6% decrease first reported.

Manufacturers cut production by 0.4% in January, so that output now stands 1.1% below last year's level. Few industries remain untouched by slack demand, and that is causing more and more factories to stand idle. Operating rates for all industry dropped to a four-year low of 79.9% in January. In manufacturing, only 78.8% of capacity was in use, with extremely low operating rates in the auto, steel, and apparel industries. Slack production schedules indicate that laid-off factory workers won't be called back to their jobs anytime soon.


The increase in excess capacity continues to take upward pressures off prices, although that wasn't so clear in the January price reports. Producer prices for finished goods dipped 0.1%, mainly reflecting a 10% drop in gasoline prices. But excluding the volatile food and energy components, prices of finished goods jumped 0.5%.

Some of that large rise probably has more to do with flukes in the government's seasonal adjustment than reality. Car prices, for example, reportedly surged 2% in January, even though car sales are the weakest in years.

Measurement problems also crept up in the government's latest report on consumer prices. The consumer price index increased by 0.4% in January and a whopping 0.8% excluding food and energy.

The Labor Dept. reported jumps in the costs of hotel rooms and apparel. But considering the heavy discounting by retailers and the slowdown in travel by consumers and businesses, these price increases should fall back in coming months. Plus, higher taxes on tobacco and liquor products caused some of the gain.

Even so, inflation may be a tougher foe than the Fed expects. Fed Chairman Alan Greenspan outlined the central bank's economic forecast for 1991 during his semiannual report to Congress on Feb. 20. The Fed expects the economy to grow in the range of 0.75% to 1.5% this year, with inflation declining to between 3.25% to 4%, as measured by the CPI.

So far, though, the recession has had little effect on consumer prices. Since last summer, the CPI excluding food and energy is up at a 5.5% annual rate, about the same as the 5.7% pace of the prior six months (chart). Service inflation remains a problem. The sluggish demand for goods is tamping down price increases in that sector--but at the expense of job and output cuts.

Indeed, the weak January production numbers mean that industrial activity started the first quarter at an annual rate of 6.7% below its fourth-quarter average. Because demand is so sluggish, output is unlikely to make up much ground in February and March. That suggests another quarter of decline for the economy.


Some of the hardest hit producers in the factory sector are suppliers to the construction industry. Output of building materials plunged 1.8% in January and has fallen by 7% since the summer. Builders and their suppliers will suffer even after the economy picks up, because new demand will be met by existing buildings.

The overload of unsold homes is acute, and that's keeping homebuilding dead in the water. In January, housing starts skidded 12.8%, to an annual rate of just 850,000--the lowest building pace in nine years (chart).

The January slide was the 11th in the past 12 months, and the slump is affecting all regions. In the South, starts fell to their lowest level on record in January, despite the region's rapid population growth.

The drop in construction is also hurting the production of home-related goods. Appliance output is down 16.8% from a year ago, and production of furniture is off 4.8%. Because these high-priced items are usually bought on credit, most households will postpone purchasing them until job prospects become more secure and interest rates for consumers fall lower.

But when spending for home goods and other items does turn around, output should increase quickly. That's because businesses are keeping very few extra goods on hand. Inventories held by manufacturers, wholesalers, and retailers fell by 0.7% in December, to $810.7 billion. That was the biggest monthly drop in nearly eight years.

Retailers, in particular, have been keeping a keen eye on inventories in order to hold down costs. In December, store inventories fell 0.8%, after falling by 0.2% in November. Heavy price discounting continued in January, suggesting that retail inventories were pared further. Troubles at stores also means production of consumer goods will remain weak this quarter.


It isn't just U. S. producers who are being squeezed. Imports fell by 7.9% in December, to $39.7 billion. After adjusting for prices, real imports are 1.5% below their pace of a year ago, with declines in cars and consumer goods chiefly responsible.

The decline in imports is helping to narrow the trade deficit. In December, the trade gap fell to $6.3 billion, from $8.9 billion in November. Cheaper foreign oil helped pare imports in December, but even excluding petroleum, imports dropped 6.1%.

But if the U. S. recession is cutting into our imports, economic slowdowns abroad are hitting U. S. exporters as well. Exports fell 2.1% in December, to $33.5 billion. Growth in exports is slowing to countries such as Canada and Britain, where economies are stagnating.

Still, the overall trend of exports is up, and the trade picture is improving. After price adjustments, the fourth-quarter deficit shrank by almost a third from a year earlier. Weak U. S. demand for imports and slower but steady growth in exports should narrow the trade gap further in the first quarter.

Looking ahead, though, manufacturing--and the economy--will need more than a shrinking trade deficit to mount a recovery. Even more cuts in interest rates from the Fed seem necessary before domestic spenders can start to see gains in incomes and profits that will help them shake off their debt problems and start buying again. Until that happens, manufacturing will be just a well-oiled machine without any gasoline.

Before it's here, it's on the Bloomberg Terminal.