What's Holding Back Recovery? Plenty

Like any good cake recipe, the formula for recovery must include a leavening agent to pump up growth. For the economy, that ingredient often is lower interest rates. As borrowing becomes cheaper, consumers and businesses boost their spending. Increased demand then raises production and hiring levels. In fact, until domestic buying picks up sufficiently, the economy will remain as flat as a cracker.

Clearly, some sectors of the economy are struggling to lay the foundations for recovery. Housing seems to have touched bottom. And foreign trade continues to offer some relief to manufacturers.

But other parts of the economy are still in trouble. Overall domestic spending remains weak, thanks to the dismal performances by personal income and corporate profits. Debt levels are still high, and an inventory imbalance relative to sales is keeping production lines from moving.


Lower interest rates would certainly help. But right now, it doesn't look as if rates will decline much more. The Federal Reserve seems to be waiting for more information on how past easing measures are affecting the economy. Since October, when the central bank started to move aggressively, the federal funds rate--the rate charged on interbank borrowings--has declined by 2 1/2 percentage points, to 5 3/4%.

The Fed has less influence at the long-term end of the borrowing spectrum, however, and rates there are proving more intractable. True, long-term rates fall by less than short-term ones during recessions. In previous postwar downturns, the average drop in short rates was about three times as large as the change in long rates.

But the spread is wider in this recession. The yield on a 30-year Treasury bond has fallen by only a half-percentage point from its recent peak. The interest rate on a three-month Treasury bill is down by about 2 1/4 points from its high point--or more than four times as much as the long-rate decline (chart). Long-term rates must fall lower to boost credit-sensitive sectors such as housing, cars, and capital goods.

Part of the problem is Washington's voracious need to borrow. Even though the recession has quashed private borrowing, the massive credit demands from the public sector are keeping long-term rates high. The Treasury's record amount of securities being auctioned off this quarter is causing weakness in the bond market. Since mid-April, the interest rate on a long-term bond has risen from 8.16% to 8.27% on May 22.

Washington's credit demands won't lessen as long as the economic downturn cuts into tax receipts. In April, the Treasury Dept. had a surplus of $30.1 billion, as Americans squared away their annual income-tax bills. But the April figure was far below the $41.8 billion surplus that the feds posted a year earlier.

For the first seven months of this fiscal year, which began in October, the federal government has spent $744.6 billion, while taking in only $623 billion. The resulting $121.7 billion deficit suggests that the federal budget will be about $245 billion in the red by the end of the fiscal year. That would be the largest deficit ever--far surpassing the record of $220.5 billion posted just last year. And the Bush Administration admits that the deficit could go as high as $300 billion.

State and local governments' budget woes only add to the fiscal mess. Like the federal government, the combined operating budget of all 50 states is in the hole for a record amount. To balance their budgets, state and local governments are likely to raise taxes. That may add to public coffers, but it could delay the recovery, because higher taxes mean less money for consumers and businesses to spend.


The housing sector, which is just beginning to show signs of life, is watching the trends in long-term interest rates very closely. Every one-percentage-point drop in mortgage rates means almost a $100 decline in the average homeowner's monthly mortgage payment.

Homebuilding's four-year slide apparently stopped in the first quarter. After sinking to a nine-year low in January, housing starts reached an annual rate of 957,000 in April (chart). That was a 6.2% gain from March's 901,000 pace.

Housing traditionally turns around before the rest of the economy, but the rebound in homebuilding won't be very robust this time. For one thing, a glut of existing apartments will hamper the construction of new multiunit projects. Starts on such housing in April fell for the fifth month in a row, to their lowest level on record.

Demographics will also keep the sector's rebound modest. New households are being formed at a much slower pace in the 1990s than in the previous two decades, when baby boomers were busy establishing their own homes.


Moreover, the recovery will not be spread evenly among the regions. Homebuilding continues to slide in the Northeast, where the recession has caused the most damage. Construction in the West picked up sharply in April, but housing starts there slumped drastically last year. That means it will be some time before homebuilders in the West can make up for last year's losses.

Housing is also being squeezed by the credit crunch. In particular, developers are having trouble getting funds to start projects. Until banks loosen their credit reins, fewer new homes will be started.

The homebuilders' grasp on recovery in their sector is very tenuous, so any rise in long-term rates would probably end the rebound. And if home buying and building start to decline again, the producers of home-related goods won't be able to climb out of their slump.


That would further dim the outlook for the factory sector--whose prospects in coming months aren't very bright anyway. Demand from abroad remains the major source of growth for manufacturers. But even this strength is beginning to wane.

Export growth has been erratic in recent months. In March, exports rose by 1.2%, to $34 billion, but they had fallen by 1.6% in February. Over the past 12 months, exports have increased by 2.7%, down sharply from the 8% pace of a year earlier. A stronger dollar and weaker economies among many of our major trading partners are holding down export gains.

Meanwhile, the recession in the U. S. is hammering demand for foreign goods. In March, imports fell by 2.7%, to $38 billion. That was the fourth drop in the past five months. Imports are down 8% from their year-ago level. The collapse of imports is narrowing the U. S. trade deficit. It decreased to just $4 billion, from $5.5 billion in February (chart). The March trade deficit was the smallest in almost eight years.

The cutback in spending by U. S. consumers is causing hard times for foreign manufacturers. In the first quarter, imports of consumer goods, excluding food and autos, were off by 4% from a year ago. And foreign-car shipments have declined by 3.5%.

The volume of oil imports last quarter was higher than in the fourth quarter, when the Persian Gulf crisis disrupted supplies. However, oil imports have dropped by 15% compared with the first quarter of 1990, when the economy was still growing.

The March trade data suggest that the gross national product's net-exports number--which was in surplus last quarter for the first time in eight years--will be refigured upward when the first-quarter GNP revisions are reported on May 29. The gain should offset declines elsewhere.

Imports will drop as long as consumer spending in the U. S. remains in a rut. As a result, the foreign trade deficit may narrow further in the months ahead. The government has already reported a 4% drop in custom duties in April. That means imports fell in that month.

The improving trade picture adds some spice to an otherwise bland outlook. But it will take more than that to cook up a recovery. The economy already has the necessary ingredient of a pickup in housing. But it still needs a generous helping of new demand, plus a pinch of lower interest rates, to get growth rising again.

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