The Third Quarter Was O.K., But Look Out For The Fourth

For all the gloomy talk lately, you would hardly believe that the economy actually grew in the third quarter for the first time since last summer. The official word comes on Oct. 29, when the Commerce Dept. reports on gross national product. But so far, real GNP is on course to post a gain -- perhaps even greater than the 2.9% annual pace now generally expected. So why all the downbeat talk?

The worry is the fourth quarter. Many of the pluses that lifted the economy in the third quarter turned into minuses as the quarter wore on. Consumer spending started out like gangbusters, ensuring a sizable contribution to GNP, but then faded. The housing recovery also added smartly to growth but then lost momentum.

In addition, the outlook for auto production, a big part of the summer gains in manufacturing, dimmed as car sales fell off. Higher factory output resulted in a reduced rate of inventory liquidation in the third quarter, which also boosted GNP growth. But without sustained demand growth, further production gains are at risk.

The government's latest batch of indicators isn't encouraging. Its leading index, which is supposed to tell us where we're headed, was unchanged in August after six consecutive gains (chart). That doesn't necessarily mean that the recovery is stalling out. But with only one exception, this is the first time in any postwar recovery that the index has stopped rising this early into an upturn. The exception was the short-lived recovery in 1980.

The index of coincident indicators, those that tell us where we are, also looks tired. Because it bottomed back in March, and given its influence in the dating of business cycles, this index strongly argues that the recovery is seven months old in October. However, after rising for three consecutive months, it stopped growing in July and edged lower in August. That's another sign that the upturn lost some steam in the third quarter. FACTORIES ROLLING, SERVICES STALLED It's not just the indicators. Companies also express growing doubt about the economy's strength in coming months. Dun & Bradstreet Corp.'s latest survey of 3,000 executives shows that business optimism about fourth-quarter sales, profits, orders, and such fell from the third-quarter reading, which was below the level immediately after the end of the gulf war. Except for the depressing period during the Mideast crisis, business optimism is the lowest in more than eight years. That's a little disconcerting this far along in a recovery.

D&B says that fourth-quarter expectations for sales and profits fell in every industry grouping. Fewer companies expected to increase prices, and the employment outlook slid back near its recession low. Wholesalers and services companies reported the sharpest declines in optimism. Retailers and manufacturers also lost confidence, but manufacturers seemed less gloomy than most.

That makes sense. As of right now, the recovery has a split personality: Manufacturing is doing well, but services are still floundering. Factory output is rising in response to the postwar pickup in spending, because businesses had shrunk their inventories during the recession. But many service companies are downsizing payrolls in an effort to cut costs and boost earnings.

The factory rebound continued in September, says the National Association of Purchasing Management's latest reading of industrial activity. The purchasing managers' index--a composite of orders, production, employment, inventories, and supplier deliveries--rose for the seventh month in a row (chart).

The index edged up from 54.8 in August to 55 in September, the highest level since December, 1988. The reading was the fourth straight greater than 50%, the dividing line between expansion and contraction in manufacturing.

Production continued to gain ground in September, according to the NAPM, and that bodes well for growth in both factory employment and inventories. The purchasers reported that companies liquidated their stockpiles at the slowest pace in two years. When the rate of inventory cutting slows, it's a plus for GNP growth.

But will businesses feel comfortable enough with the pace of demand to start adding to their inventories in the fourth quarter, thus giving the economy a further boost? Only consumers can answer that question.


Consumers spent like there was no tomorrow at the beginning of the third quarter. Inflation-adjusted outlays rose 0.6% in July, the strongest increase since the 1.1% surge in March at the end of the gulf war. However, spending fell by 0.2% in August. And in September, judging by weak car sales and the decline in consumer confidence, spending was tepid as well.

Still, even if outlays were unchanged last month, spending for the third quarter would rise at an annual rate of 3.7% from the second-quarter level. That's a sizable boost from a sector that is two-thirds of GNP.

The third-quarter jump in spending comes on the heels of a 2.5% increase in the second quarter. Those two gains more than make up for what consumers gave up during the recession. There's only one problem: Consumers' incomes have lagged far behind their spending, and that's a red flag for fourth-quarter outlays.

To be sure, consumer income has grown this year, but not at a clip capable of supporting the pace of spending that consumers have enjoyed. Both outlays and aftertax earnings, adjusted for inflation, hit bottom in January. Since then, real spending on goods and services has risen at an annual rate of 3.9% through August. Real income is up only 2.1% (chart). With consumers already in poor financial condition, that pattern cannot continue without a freshet of income.


In order to spend at that rate, households have drained their savings from 4.8% of aftertax income in January to 3.9% in August. This savings ratio is far lower than in the early stages of any past recovery.

So, consumers cannot rely on their savings to finance future purchases.

Heavy debts are weighing on new credit purchases. In the second quarter, all consumer debt outstanding stood at a record percentage of aftertax income. In July, consumers liquidated their installment debt at a record clip. That has helped to reduce the interest cost of their debt, but heavy mortgage interest has kept overall debt service very near its alltime high set in the first quarter.

Lower interest rates will eventually help consumers to deal with their debts, and they are already showing some positive results on home sales. Although purchases of existing homes fell in both July and August, sales of new single-family homes rose 6.7% in August, to 540,000, after declining in July. However, lower rates cut two ways. They are also depressing interest income, which is now falling at the fastest rate in the postwar era.

Consumers also have to devote more of their earnings to taxes. In the year ended in August, all taxes paid by individuals to all levels of government stood at a record 20% of personal income. Moreover, the tax bite on consumers has risen steadily during the past two years, the first time it has done so during a recession.

Income gains are increasingly the only option available to consumers for continued growth in spending. And that depends on the job market. But job gains at factories cannot carry the load when service producers employ three-fourths of all workers.

Indeed, new claims for unemployment insurance began rising again in mid-July, and in late September they stood at the highest level since early June. Also, the Conference Board reports that its index of help-wanted advertising continued to fall in August to the lowest level in eight years, another sign that jobs are hard to come by (chart).

So when third-quarter GNP comes out, the Bush Administration will declare victory over the forces of recession, and most economists will feel pleased with themselves for forecasting the recovery. But unless employment and incomes start growing faster, fourth-quarter GNP could be an entirely different story.