At Best, The Economy Is Dead In The Water

A bombardment of bad economic data has forecasters running for cover. Pounded by disappointing October reports on job growth, consumer confidence, car sales, and industrial activity, many economists are sharply scaling back their near-term expectations for the economy. Most still dismiss the prospect of an outright drop in real gross national product this quarter, but not even that can be ruled out just yet.

According to Blue Chip Economic Indicators, which surveys economists across the nation, real GNP is expected to grow at an annual rate of only 1.9% this quarter. That November average of 53 forecasts is down nearly a full percentage point from the October projection of 2.8%. Blue Chip's Robert J. Eggert calls the downshift "one of the largest quarterly drops we've seen from one month to the next" in the publication's 15-year history.

This sudden caution is well justified. The economy stopped growing in July, according to the Commerce Dept.'s composite index of four coincident indicators, which tracks the economy's monthly path. And in October, hours worked in nonfarm businesses, which are a good proxy for economic activity, began the fourth quarter below the third-quarter average.

Going into the fourth quarter, the numbers are saying that the recovery is, at best, dead in the water. At worst, the economy is on the verge of a renewed downturn.


The failure of the economy to pick up the way most forecasters had expected casts a new light on the outlooks for inflation and interest rates. Prospects for lower inflation in 1992 are much brighter now -- even despite the menacing look of October's producer price index.

Producer prices of finished goods rose a steep 0.7% last month -- with a disturbing 0.5% increase in the core PPI, which excludes food and energy. Quirks in seasonal adjustment, particularly in the index for consumer durable goods, accounted for some of the unexpectedly big gain, but prices of nondurable consumer items also accelerated, as did costs of capital equipment.

However, the October PPI looks like one of those one-month aberrations that does not signal a reversal of the slowdown in goods inflation (chart). In a climate of weak demand and idle capacity, goods producers, carmakers especially, will find it tough to make large price hikes stick. Sales of domestically made autos sank in early November to a dismal 5.7 million annual rate.

Heading into next year, the economy just doesn't have the ability to grow fast enough to keep inflation propped up. For the past 10 quarters, real GNP growth has averaged 0.5% a quarter with no gain greater than the economy's long-term growth trend of 2.5%. This pattern seems unlikely to change soon, and price pressures can build only if growth is sustained above its long-term potential.

At the same time, however, the combination of tepid economic growth and falling inflation severely limits the economy's ability to generate incomes for consumers and profits for business. In particular, companies have little pricing power, which keeps the squeeze on profit margins, despite continued cost-cutting.

Based on the third-quarter GNP data, BUSINESS WEEK estimates that corporate operating profits fell to an annual rate of $281.6 billion last quarter, from $ 284.4 billion in the second quarter. Moreover, operating earnings as a percentage of gross domestic product also fell slightly, suggesting that margins were still under pressure last quarter.

If fourth-quarter demand shapes up the way forecasters expect -- or worse -- the pinch on margins is sure to continue. Despite companies' past efforts to cut costs by laying off workers, even more jobs may be lost as businesses struggle to improve their profit margins. If so, that will keep the squeeze on consumer incomes as well.


A weak economy and receding inflation mean that interest rates -- both short and long -- may be headed lower than many economists had thought. Despite the Federal Reserve's 13 cuts in the federal funds rate, from 8 1/4% last fall to 4 3/4% now, the dearth of bank lending continues. Banks are using their funds to restructure past bad loans, meet higher capital requirements, and satisfy strict regulators, rather than make new loans.

Loan demand is also weak, but banks have not dropped their prime rates as much as the Fed's huge easing would usually make room for (chart). The prime rate, currently at 7 1/2%, is nearly 60% larger than the fed funds rate. Banks have not enjoyed a spread that wide since just after the 1969-70 recession.

In the 1980s, the prime averaged 20% above the funds rate. That spread implies a prime rate below 6%. Because of the unique depressants on the banking system, the Fed may have to ease policy more than it has in the past in order to shake the economy out of its daze.

Stubbornly high long-term rates are another problem. Tax-cut fever threatens an even bigger flood of Treasury borrowing, and reports like the October PPI keep inflation fears alive. However, as inflation's improvement becomes more evident, long rates will drift lower.


The central bank's aggressive easing on Nov. 6 was supposed to torpedo the growing worries about the recession's return. But for consumers, the Fed's actions during the past year have been a dud. The cuts in the federal funds rate have resulted in little, if any, reduction in the borrowing costs of consumers.

In the past year, for instance, the central bank has cut the fed funds rate by 3.75 percentage points. But the average lending rate for a 30-year fixed mortgage has fallen by just 1.3 points, to 8.83%. And the average interest rate on a credit-card balance has actually increased slightly to 18.78%, from an already hefty 18.76% a year ago (table).

Until borrowing costs fall appreciably, households are unlikely to buy such rate-sensitive items as homes, cars, and appliances. And without the thrust from consumer demand for big-ticket items, this recovery doesn't have the fuel to keep going.

In September, consumer installment credit dropped by $1.5 billion, its fifth consecutive decline. Installment debt outstanding is now equivalent to 17.6% of disposable income, down from the record 18.9% hit in late 1989. In particular, consumers are steering away from car loans. Auto financing dropped $ 2.3 billion in September and has been declining steadily since March, 1990.

One area where consumers did accelerate their borrowing in September was revolving debt, mostly credit cards. Such credit increased $2.4 billion, the largest monthly gain since March. Although households are paring total installment debt, revolving credit has risen to 5.6% of disposable income -- the highest ratio since the Fed started to track consumer borrowing in 1975 (chart).

The rise in revolving credit is unusual in the early stages of a recovery. And in today's environment of sluggish consumer spending and stratospheric charge-card rates, the growing use of plastic may be a sign of distress borrowing by financially strapped consumers. Indeed, consumer spending has far outpaced the gains in aftertax income this year. And the increase in revolving credit in September came when retail sales, aside from autos, were extremely sluggish.

With households struggling to make ends meet, consumers may rely heavily on credit cards during the holiday shopping season. That might add some luster to what is expected to be a blue Christmas for retailers. But when the first quarter of 1992 rolls around, consumers will just have to channel more cash to debt repayment. With job and income prospects looking shaky, that would end up hurting the recovery.

So far, amid all the shelling from shaky consumer fundamentals, stingy banks, paltry profits, and the like, the Federal Reserve's rate cuts have provided the recovery with some measure of shelter. However, they might not be able to prevent a direct hit to fourth-quarter GNP.

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