Empty Pockets Are Still Keeping Recovery On Hold

It has been clear for some time that the U. S. economy got off to a bad start in the first quarter. Just how bad is now coming into view. The data virtually assure that real gross national product will post its second consecutive decline, following a 2% dip in the fourth quarter. The current quarter's drop is shaping up to be at least as steep as last quarter's. And despite the war's end, prospects for the second quarter are not encouraging, either.

That's because financially strapped consumers are leading the economy's retreat (chart), and other sectors are following in lockstep. Consumer spending, housing, business construction, and capital-goods shipments all began the first quarter well below their fourth-quarter levels. Altogether, that's four-fifths of GNP.

The breadth of the first quarter's weakness is a sign that the economy's problems run deep. It also argues that a rebound fueled solely by postwar optimism may be too much to expect. The oil shock may have snuffed out the expansion, but because the recession has seriously eroded the fundamentals in many sectors, peace in the gulf alone will not necessarily ignite a recovery.


Recovery signals are faint at best. The government's index of leading indicators fell 0.4% in January, after a 0.1% dip in December. Those were the smallest of the six declines since last August, and the February reading may be up, buoyed by the surge in stock prices, better consumer expectations, and faster growth in the money supply. Still, the lead time between the trough in the leading indicators and the first month of recovery has been extremely variable--from 1 to 10 months.

Manufacturers are still mostly hunkered down, just waiting it all out. In the meantime, new orders are falling, the order backlog is shrinking, and factories are still laying off workers in an attempt to keep inventories under control. Factory orders fell 1.7% in January, the fourth drop in the last five months. And since October, manufacturers' inventories have risen sharply in relation to shipments.

Factory conditions didn't look much brighter in February, says the National Association of Purchasing Management. The NAPM's index of industrial activity edged up to 38.5% from 37.7% in January, but readings below 44% mean that the economy is still in recession (chart). The most important question is: Now that the Iraqi army has laid down its weapons, will American consumers bring out their heavy-spending artillery? Economists looking for a spring recovery are pinning their hopes on a rebound in consumer spending. But the latest news from consumers suggests that households still don't have enough cash to increase spending by much, if any.


Personal income in January fell by 0.5%--its biggest decline in two years. Wages and salaries dropped 0.5%, with factory earnings down 1.5%. And consumers have a thin cushion of savings. They put away only 4.3% of their aftertax earnings in January. That rate differs little from the average of the past two years, and it's way below the 7.2% saved during the last recession.

Then there's the question of consumers' heavy burden of debt. Installment credit as a percentage of aftertax income was much higher going into this recession than at the beginning of the last downturn. And more stringent lending rules at banks make credit tougher to get.

Paychecks look even punier after accounting for inflation and taxes. Real disposable income was down a sharp 0.9% in January. That almost assures a third consecutive quarterly drop in the buying power of incomes, something that hasn't happened in the postwar era. Further layoffs and smaller pay raises suggest weak earnings in coming months as well.

With less green in their wallets, it's no wonder consumers are so blue. The index of consumer sentiment, compiled by the University of Michigan, increased 5.4% in February, but it is way below its pre-August level. Attitudes about current economic conditions fell by 1.4% last month and stand 18% below their year-ago reading.

People are more optimistic about the next six months, though. Consumer expectations jumped by 12.3% last month, probably because those surveyed hope that a quick end to the gulf war will help end the recession. The trouble with this argument is that heightened optimism is based on an economic recovery, meaning that consumers will have to fulfill their own expectations.

It will not be easy. Consumer sentiment remains far below its summer level, indicating that job security, slower income growth, and high debt levels have also been keeping many shoppers at home. Those economic strains won't go away with the end of the war. And that's why a spring turnaround is unlikely.

Consumer spending is on a downward slide as steep as those during the two severest recessions of the last 40 years. Outlays dropped 0.6% in January, to an annual rate of $3,718.6 billion. After price changes, buying fell 1.1% and was 1% below its year-ago level.

Outlays had declined at an annual rate of 2.9% in the fourth quarter. The January drop means that spending started off the first quarter at an annual rate of 3.4% below last quarter's level. Even if consumers mount some kind of postwar rebound, outlays this quarter will still fall sharply, creating a big drain on real GNP. And for the second quarter, weak household finances suggest that any such bounce-back will be small and temporary.


The latest numbers on sales of cars and homes, necessary ingredients for any real consumer turnaround, also don't offer much hope. Sales of new domestically made cars remained weak in late February, at an annual rate of 5.9 million, leaving the rate for the month at only 6 million. That was little changed from 5.9 million in January, and it means overall consumer spending in February was probably lackluster as well.

Homebuying has been on the skids for about two years now. In January, new single-family home sales slid 12.3%, to an annual rate of 408,000, even though mortgage rates were dipping below 10%.

Anecdotal reports indicate that home sales picked up toward the end of January. That rise may have continued into February, as buyers began to take advantage of last month's fall in mortgage rates. But in early March, long-term interest rates started to edge up again. Without further declines in mortgage rates, any turnaround in homebuying will be limited.

That would mean more problems for homebuilders, who are already wrestling with stricter bank-loan requirements and a glut of unsold homes. At the January sales rate, it would take 9.3 months to clear out the existing supply of new homes (chart). That's the largest supply in almost nine years. Until that stock is whittled down, construction activity will remain listless.

The plunge in outlays for residential buildings has led the nationwide drop in construction spending. Total outlays dropped 2.6% in January, to an annual rate of $396.6 billion, the 10th consecutive month of decline. Total outlays are now at a four-year low, and the ongoing deterioration in construction contracts is a sign that the decline has further to go. That's another big drag on GNP growth in addition to the one from consumer spending.

About the only outlays that households are still making are for items that could be classified as essentials, or not postponable. Spending on housing, food, gas, heating oil, medical care, and drugs--about half of all outlays--continues to increase, but at a weak pace.

Spending on more discretionary items is where consumers are cutting back. Demand for these postponable goods and services has fallen 4.3% during the past year. Holding off on vacations, new cars, and home improvements creates the pent-up demand that will propel this economy into recovery. But unleashing that demand will require an improvement in household finances. That means better real-income growth, lower debt levels, and a bigger savings cushion.

Consumers may feel better about their future now that the war is one less thing to worry about, but if an economic recovery is going to get under way, they'll have to back up their optimism with hard cash. And right now, they just don't have it.