If Demand Stays This Low, The Slump Won't Budge

Waiting for an economic recovery is becoming a little like waiting for Godot. Unlike that mysterious character, however, an upturn will eventually arrive. But before the economy can rebound, it has to stop falling. There's just no sign of that. Real gross national product dropped faster in the first quarter than it did in the fourth. And the data show that the second quarter is off to a bad start. Right now, the wait is looking more like months than weeks.

The 0.5% increase in the March index of leading indicators, following a 1.2% rise in February, appeared to offer some hope. But excluding a postwar surge in consumer expectations, which has not generated new spending as anticipated, the March index would have fallen by 0.3%.

Apparently, the Federal Reserve Board is getting impatient. On Apr. 30, in an effort to nudge the economy, it cut the discount rate--its borrowing charge to banks--from 6% to 5 1/2%, and shaved a quarter-point off the federal funds rate--the cost of interbank loans--from 6% to 5 3/4%. In the wake of that policy easing, big banks are cutting their prime rates from 9% to 8 1/2%. That's a good sign for recovery, but it is also an admission that past easing has not been sufficient to do the job.


Meanwhile, the slump deepens. We now know that the 1990-91 recession began last July. That means it is in its 10th month, only one month short of the average for the postwar era. To date, the downturn is shallower than usual, at least as measured by the decline in real GNP. However, gauged by the drop-off in domestic demand, it is far more severe (chart). And that is a big reason why the recession will be longer than average.

The Commerce Dept. reported that real GNP fell at an annual rate of 2.8% last quarter, on top of the 1.6% decline in the fourth quarter. However, domestic demand--consumer spending, investment by businesses in new buildings and equipment, homebuilding, and government outlays--dropped a steep 4.3% last quarter, following a 2.2% dip. This means that the economy may be a lot weaker than the GNP data suggest.

Now, the economy faces some new problems. Dramatic improvement in foreign trade has taken up the slack between domestic spending and GNP, but it might not last. Most economists had expected rising exports and a slowdown in imports to ease the recession's pain, but they didn't expect the largest two-quarter swing in the trade balance on record. The trade deficit in goods and services turned into a surplus in the first quarter for the first time in eight years.

Economic fundamentals just aren't consistent with trade improvement at that pace. It probably reflects a temporary drop-off in oil imports and other one-time factors related to the war. In addition, the stronger dollar and weakening economies abroad are hurting exports. Foreign trade in the second quarter is likely to fall back into deficit, resulting in a subtraction from GNP.

A preemptive strike against excessive inventories is also softening the recession's blow, but the work may not be finished. Companies slashed their stock levels sharply during the past two quarters. But with domestic spending so weak and foreign demand looking shaky, even more liquidation may be necessary. That threatens to drag out the recession.

Indeed, factories may not be cutting their stockpiles fast enough. Manufacturers' inventories fell by 0.6% in March; shipments plunged by 1.9%. Since October, factories have cut their stockpiles by 1.3%, but demand has plummeted by 9.2%. And the ratio of inventories to shipments has jumped to 1.69 in March--a five-year high.

That means the slump in manufacturing has further to go. Indeed, the National Association of Purchasing Management's index of industrial activity continued to look weak in April. Although it edged up from 40% in March to 42.1%, it remains well below the 50% mark, indicating that the factory sector in still mired in recession.


Getting a recovery off the ground won't happen until consumers and businesses reverse their spending slump. Right now, the outlook for a turnaround in demand isn't very bright. Personal incomes and factory orders continue to fall, and nonresidential construction remains uninspiring. For housing, at least, the worst may be over, but the rate of improvement is likely to be slow.

Consumers need the most help. All they have right now is their optimism, and even that may soon fade (chart). Real consumer spending--two-thirds of GNP--slipped 1.4%, at an annual rate, in the first quarter, on top of a 3.4% plunge in the fourth. The monthly buying pattern suggests more hope, but much of the gains in February and March reflected special factors in car buying and utility use that boosted the numbers.

The downturn in buying is easy to explain. Consumers can't spend what they don't have. Personal income edged up at an annual rate of just 1.4% in the first quarter, with only a 0.2% gain in March. Adjusted for prices and taxes, real disposable income shrank by 1.6% last quarter, the third quarterly drop in a row. During the past year, real incomes have fallen by 1.4%, one of the severest yearly drops on record.

With incomes falling faster than spending, consumers continue to give short shrift to thrift. Households saved only 3.7% of their disposable income in March--the lowest rate since November, 1988. That's not much of a cushion. And judging by past recessions, consumers are more likely to try to save their cash than spend it.


But hope--if not money--springs eternal among consumers. That's the word from the Conference Board's latest household survey. Consumer confidence in April fell only slightly, to 79.2, from 81.1 in March. Expectations about the future stayed fairly high, but consumers said that their present economic situation continued to deteriorate. That could make it difficult for consumers to hang on to their hopes for the future.

But optimism about the future may be helping home buying, though low savings and falling incomes will keep the housing recovery lackluster. New homes sold at an annual rate of 490,000 in March. That 1% gain followed an 18.6% jump in February. The two increases suggest that housing may have hit bottom last quarter.

But right now, every bit of good news seems to be overshadowed by some bad news. For example, capital spending by businesses for new buildings and equipment is starting to weaken. Overall construction contracts fell by 4% in March, says the F. W. Dodge Div. of McGraw-Hill Inc., and contracts for nonresidential building fell sharply. The drop suggests that business investment in new structures, already down at a 3.4% annual rate last quarter, will remain weak this quarter.

Businesses are also unlikely to invest much in new equipment. Factory orders for capital goods were off sharply in March, suggesting that equipment spending, which fell at a 16.6% annual rate in the first quarter, continues to sag in the face of weak consumer demand.


The pervasive weakness in domestic demand should make it clear that inflation worries are becoming moot. The price indexes in the latest GNP report spooked the financial markets because they rose by an unexpectedly large amount. However, the seeming acceleration had more to do with the recent fluctuations in the price of imported oil than with any real speedup.

The most encouraging sign for lower inflation is the ongoing slowdown in labor costs. The government's employment cost index rose only 4.6% during the past year, and annual gains have been getting smaller (chart). Slower growth in wages and benefits in both manufacturing and services will help to temper price increases during the remainder of the year.

The promise of lower inflation is a key reason why, unlike Godot, a recovery will eventually show up. Lower inflation will bring lower long-term interest rates that are needed for sustainable recoveries in housing, autos, and other credit-sensitive areas of demand. In the meantime, though, waiting for recovery could drag on well into the second half.

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