The Recovery May Be Here, But Hold Your Applause

American businesses and consumers can rest easy now: The White House has declared that the 1990-91 recession is over. Never mind that the downturn was under way for about eight months before Washington even acknowledged it. However, don't sit back and put your feet up just yet. It's still not clear if the economy's batteries are strong enough to keep a recovery going--let alone power a vigorous one.

The Bush Administration doesn't have the final word, but the latest data make a compelling case. The government's chief forecasting gauge, the index of leading indicators, rose 0.8% in May. It was the fourth consecutive gain--a string that has always led to a recovery.

More important, the index of coincident indicators, those that plot the economy's present course, turned up in May for the first time since the downturn began in July, 1990 (chart). It rose 0.2%, after no change in April.

The coincident index--comprised of industrial output, employment, real income, and business sales--is instrumental in determining the peaks and troughs of the business cycle. As the numbers now stand, the index implies that the recession ended in either March or April.

The June report from the National Association of Purchasing Management certainly suggests an end to the manufacturing recession. The NAPM's index of industrial activity jumped to 50.9% in June, from 45.4% in May (chart). It was the fifth consecutive increase, and a reading greater than 50% implies that the factory sector is now expanding instead of contracting.

The NAPM said that production rose for the first time in a year, and that new orders posted the largest gain in 8 1/2 years. In addition, the government reported that factory inventories fell a steep 0.8% in May, to $382 billion. And the NAPM said that its June index of inventories shrank to the lowest level since January, 1983. By keeping fewer goods on hand, manufacturers are ensuring that any increase in demand will translate almost immediately to a rise in output.


If it were not for a lot of nagging questions, the recovery process from here on would be cut-and-dried. One of the biggest concerns is the inconsistency between a sick financial system and a healthy economy. Money still makes the world go round, but as of right now, the growth of various measures of money and credit seems far below the pace that's necessary to fuel a lasting recovery.

Money was a major topic when the Federal Reserve's policy committee met on July 2. The central bankers not only set credit conditions for the weeks immediately ahead but also had to determine their targets for the growth rate of the money supply for 1992.

The Fed will disclose those objectives later in the month. Its current target range for M2, the most closely watched money measure, is 2.5% to 6.5%. M2 is presently growing in about the middle of that range.

However, 4.5% growth in M2 is very low compared with past recoveries. It is also troubling because faster money creation eventually translates into either economic growth or inflation. Set against the current 4%-to-4.5% pace of inflation, nearly all the expansion in M2 is accounted for by higher prices. That leaves almost no room for growth in real gross national product.

The only way real GNP can expand appreciably faster would be if money in the system were to turn over more rapidly. But history shows that money's turnover rate--or velocity--tends to fall in a recovery. The simple conclusion is that, unless the Fed allows a faster pace for M2, even a modest recovery--on the order of 3% economic growth in the first year--seems very doubtful.


The credit crunch in the banking system is only making matters worse. The current squeeze is not the classic variety but a hybrid brought on by increased regulatory scrutiny of bank loans, particularly for real estate, on top of banks' already shaky balance sheets. Those ledgers have been weakened by past bad loans, new capital requirements, and higher deposit insurance premiums. The result is an unwillingness of many banks to make the loans a growing economy needs.

During congressional testimony in June, Fed Chairman Alan Greenspan admitted that the central bank was still wrestling with the problem. Banks seem more willing to lend to home buyers and the U. S. government than to businesses. Bank purchases of Treasury securities are up more than 12% from a year ago, but many builders and others are being turned away.

New rules on creditworthiness appear to be affecting a broad array of potential borrowers. The growth rate of loans for commercial and industrial purposes, real estate activity, and personal borrowing shows no sign of having picked up during the past three months (chart).

In fact, since March, aggregate loans in these sectors have fallen. That could reflect a weak economy, unwilling banks, or a combination of both. At any rate, it's not the kind of pattern you would expect to see from loan growth in a recovery.

The difficulty in getting loans is hurting builders, especially outside the housing sector. Total construction spending fell 0.9% in May, with outlays for new factories, offices, and other commercial projects falling steeply. In addition to the credit crunch, the oversupply of nonresidential buildings is another reason for the industry's problems.

Building contracts--a precursor of future construction activity--also turned down in May. They fell 5.3% to an annual rate of $216.8 billion, according to McGraw-Hill Inc.'s F. W. Dodge Div. Total contracts so far this year are running 16% below their pace of 1990.

Despite the recent firming in housing demand, the Dodge report notes that past overbuilding of apartments and the problems in the banking system could dampen the strength of the housing sector's rebound. So the economy as a whole still cannot count on much support from the nascent recovery in housing.


There is still plenty of doubt about the outlook for the consumer sector as well. Consumer spending last quarter increased three times faster than incomes. Given that earnings had fallen in each of the three previous quarters, such profligacy raises a serious question: How are households going to finance their outlays this quarter?

Consumer spending jumped a strong 0.9% in May, after adjusting for price changes. The gains were fairly widespread, although big increases were posted in new-car buying and in electricity use during May's hot spell. The weather caused earlier-than-usual buying of summer merchandise, however, which may have stolen some sales from June and July.

Consumer purchases are on track to rise at an annual rate of about 3.5% in the second quarter, a sign that overall GNP growth will be in the plus column. But income gains haven't been nearly as stellar. Personal income increased a strong 0.5% in May. But after taxes and inflation, second-quarter earnings are only growing at slightly more than a 1% annual rate.

Little wonder, then, that households are dipping into their rainy-day funds. Savings as a percent of disposable income fell to 3.6% in May, down from 4% in April and 5.3% a year earlier (chart).

Personal income will take another hit in July. That's when most new state and local taxes kick in, because July 1 marked the beginning of most state fiscal years. Tax hikes will shrink take-home pay at a time when savings are low and credit is hard to get for many households. That's why consumers will be unable to keep up their rapid pace of buying during the third quarter.

The tax squeeze, added to the financial problems of sluggish money growth and the credit crunch, makes it hard to see the economy revving up for a robust rebound. The White House may say the recession is over, but the lethargic pace of economic growth in the coming months won't make it feel like much of a recovery.

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