A Winter Break By Consumers Could Put The Recovery On Ice

The recovery is entering a critical period. Most economists agree that the upturn is five or six months old, but the data portray an economy that is--at best--just keeping its head above water. The numbers through yearend will show whether it sinks or swims.

The third-quarter report on gross national product should look seaworthy. Real GNP is generally expected to have risen about 3%, at an annual rate, following a 0.5% dip in the second quarter. The lift came from consumer spending, housing, and a slower pace of inventory liquidation--a plus for GNP. The economy might have grown even more than forecasters expect, depending on the size of the slowdown in inventory cutting.

However, the monthly and weekly data through the quarter tell a more downbeat story. Consumer spending and housing began last quarter on the upbeat, but by quarter's end, consumer buying had weakened, and housing had failed to build on its earlier gains. That trailing off could spell weakness for fourth-quarter GNP.

That's a big reason why the Bush Administration is looking into various strategies--including tax cuts--to prod the economy. It's also why monetary policy at the Federal Reserve remains biased toward lower interest rates.

Even with the recent cuts in the federal funds rate, the latest economic data give the Fed plenty of excuses to ease policy further. In September, retail sales were lukewarm. Producer prices supplied a very favorable reading on inflation, and in late September, the M2 measure of the money supply fell again.

Also in late September, initial claims for unemployment insurance rose. The four-week average of claims has been drifting up after falling from April to July (chart). That's another sign that the recovery may be losing momentum. BIG


The immediate concern is consumers, who supplied the spark that pulled the economy out of recession. Their optimism surrounding the end of the gulf war fueled a burst of spending, especially for cars and homes, which lifted factory orders, output, and employment. However, the latest numbers suggest that consumers might have spent too much, too fast.

The failure of the recovery to take hold means that consumers' finances have not recovered as fast as their appetite for goods and services. Job markets have not strengthened very much, which means that incomes and confidence in the future are dragging.

Retail sales in September were less than impressive despite a strong-looking 0.7% increase. The gain was fueled by a 3% jump in sales of new autos. However, most of those cars were bought by companies, especially car-rental agencies, and not by consumers. Excluding car buying, other retail purchases edged up just 0.1% last month after falling 0.2% in August.

Most retail categories exhibited a zigzag pattern. Purchases of building materials, furniture, general merchandise, and groceries all rose in September after falling in August. Apparel and drugstore receipts dropped last month after no change in August. Only gas stations managed back-to-back advances, and that likely reflected rising prices, not a gain in volume.

In fact, after adjusting for inflation, real retail sales have gone nowhere since May (chart). In the third quarter, real sales were up by only 1% from the second quarter at an annual rate. And they remain below their pace of a year ago.

Since hitting bottom in January, inflation-adjusted consumer spending on both goods and services has risen nearly twice as fast as aftertax incomes. At the same time, households are devoting more of their income to paying off debt, and their savings are down to a pittance. Consumers might need a breather in the fourth quarter. If they take one, the recovery will surely suffer.


Judging by car sales, October consumer spending didn't get off to a very good start. After corporate buying lifted late-September car sales, new domestically made autos sold at an annual rate of only 5.5 million in early October. That pushes car purchases back to their dismal pace of the first 20 days of September.

Car sales reached a high for the year in July, at 6.8 million, but since then, they have trailed off. They dipped to 6.1 million in August and edged up to 6.3 million in September before hitting the sour note in early October.

Slumping car sales may be an early sign that consumers are about tapped out as they head into the fourth quarter -- and the holiday buying season so crucial to retailers. Weak car buying also raises doubts about auto production this quarter. If sales don't pick up, fourth-quarter output plans will have to be scaled back, and that would undercut GNP growth.

If consumers pull back broadly, businesses will have little incentive to lay in new stockpiles of goods. And without inventory rebuilding, the production and employment rebounds in manufacturing will fall flat.

Production gains during the summer caused a sharp slowdown in the pace of inventory liquidation. Business inventories dipped 0.1% in August, to $806.2 billion, after holding steady in July, but that followed much larger cuts of 0.6% in both May and June. Adjusted for inflation, inventories continued to decline, but the cuts were smaller (chart).

The swing from a big decline in inventories in the second quarter to a smaller decline will add handsomely to third-quarter GNP. But if consumer demand fails to boost ordering in the coming months, factory output and inventory building won't provide much help for fourth-quarter GNP.


Even if economic growth isn't performing as strongly as it typically does during the early stages of recovery, at least inflation is following its usual path--downward. Producer prices of finished goods were up by a mere 0.1% in September, and when food and energy prices are taken out, they were flat.

Some of the best inflation news, however, is coming from food and energy. In the third quarter, the wholesale cost of food dropped by a 6.6% annual rate--the biggest decline in 15 years. Energy prices rose in August and September, but they remain below their pace of a year ago, when the Iraqi invasion of Kuwait sent oil prices soaring. In particular, gasoline and heating oil are 24% cheaper than they were a year ago.

Improvement in inflation at the wholesale level has been fairly sharp--and it goes far beyond food and energy. Prices of finished goods, excluding those two items, rose by only 3% in the past 12 months. In January, they were rising by 4.1% (chart).

Moreover, inflation has become almost nonexistent in the prices paid by manufacturers for supplies and crude materials. Costs of intermediate supplies and materials, excluding food and fuel, were flat in September and stand slightly below their level of a year ago. Crude-materials prices fell by 0.9% in September, and they have dropped some 10.2% during the past year.

The sluggish pace of economic growth is causing a reversal of some earlier price increases. The housing recovery, for example, which started in the first quarter, began to lose steam in the summer. And the costs of construction materials weakened in the third quarter after rising at a 3.6% annual rate in the three months before that.

The fall in the cost of input materials reduces some of the price pressures on the makers of finished consumer and capital goods. That means inflation should remain under control into 1992.

In one important sense, however, the bright outlook for inflation is a direct result of the abnormally weak growth in demand that has robbed the recovery of its expected buoyancy. The immediate problem is that if consumers fail to maintain their spring and summer spending pace, the economy may not be able to stay afloat in the turbulent waters that lie ahead.

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