The Recovery Was A Lemon To Begin With. No Wonder It Broke Down

A few weeks ago, you could argue that people were too gloomy about the economy. Not any more. Since late summer, the recovery's engine has quit firing on one cylinder after another. Housing tanked, then autos, then retail sales. Now, as inventories pile up, growth in industrial output has withered. By most measures, the weak recovery has ground to a halt.

Wall Street is beginning to share Main Street's uneasiness. The stock market is in its worst sell-off in two years. Share prices tumbled on Nov. 15 and slipped further on Nov. 19, mostly reflecting worries about the recovery and Washington policy. The market's slump only feeds the sour mood of consumers and businesses. Moreover, a stock shock now could be a death blow to a fragile recovery. The market plunges in October, 1987, and October, 1989, turned out to be benign, partly because the economy was stronger then.

The economy is not simply the victim of a national mood swing. The recovery is stalling out because it was built on shaky fundamentals. The pickup in consumer spending after the gulf war started a virtuous cycle that shrank inventories and generated orders and production that lifted the economy.

However, job growth remained weak, while consumers spent twice as fast as their incomes were growing. Savings dried up, and debts didn't go away. The economy's web of interrelated structural problems in government finance, real estate, and banking didn't go away, either. Those problems still weigh heavily on demand.


With all this falling back on consumers, that virtuous cycle is now starting to unravel. Spending has fallen behind output, and retail inventories are starting to bulge (chart). Retail sales fell by 0.1% in October, and the August and September data were revised lower. After adjusting for inflation, sales began this quarter about even with their third-quarter level.

Car buying is in particular trouble. Sales at dealerships fell 0.3% in October. And car sales in early November were a disaster, another worrisome sign that consumers just aren't consuming.

Other retailers, however, aren't much busier. Nonauto sales were flat in October and haven't risen since July. Purchases at furniture, department, and apparel stores fell in both September and October. Receipts at these stores are back to where they were in June.

The big danger for the fourth quarter is that consumers are retrenching just as the important holiday shopping season gets under way. The latest findings on household attitudes are ominous. The University of Michigan's preliminary reading of its index of consumer sentiment shows a steep decline in November. That drop suggests that the plunge in the Conference Board's October index of consumer confidence was not a fluke.

Consumers' concerns are not misplaced. Companies continue to announce layoffs, especially in the white-collar ranks. And new claims for unemployment benefits jumped to a 454,000 annual rate in early November, the highest pace since May.

These worries are holding back the recovery in homebuilding. Housing starts rose by 7.3% in October, to an annual rate of 1.1 million (chart). Homebuilding is up by 29% since hitting its low point in January, but the rebound has been modest by the standards of past recoveries.

Starts of multifamily units, up 26.2% in October, accounted for the bulk of the month's increase, while single-family homes rose 3.9%. However, that increase came on the heels of a 13% plunge in sales of new homes in September, the largest drop in 2 1/2 years.

The sales drop-off raises questions about the strength of home demand, which could temper builders' enthusiasm in coming months. The sharp fall in mortgage rates -- now down to their lowest level since 1977 -- is not offsetting consumer worries about future job and income prospects.


With those concerns keeping shoppers away from their local malls, retailers are bracing for a Christmas that only a Scrooge could love. If those expectations become reality, unwanted inventories will build up further, and retailers will finish the year with bulging warehouses. That will lead to cuts in output, payrolls, and profits in 1992.

It may already be happening. Business inventories jumped 0.6% in September, following no growth in July and August and declines during the five previous months. The September increase was the largest since July, 1990, and it was concentrated in retail trade. However, with retail buying going nowhere, much of that accumulation appears to be unintended.

Retail inventories rose 1.5% in September, the largest increase in three years. Since June, stockpiles held by retailers are up 2.2%, while retail sales have increased a mere 0.3%. The October sales decline didn't help matters.


The growing problem of retail inventories carries one benefit for holiday shoppers: It brightens the inflation outlook. Merchandisers may have to discount heavily to move their goods. Already, inflation at the retail level is moderating, and more improvement is likely.

The consumer price index rose a mere 0.1% in October. Excluding food and energy, the core rate of inflation was also up a small 0.1%. The gains in the total CPI and the core rate were the smallest since March. Over the past year, both measures of inflation have come down considerably (chart).

The stellar performance of the October CPI was important because it came on the heels of October's alarming 0.7% jump in producer prices, which seemed to suggest that inflation was flaring up again. The CPI report lays that fear to rest. Weak domestic demand is preventing businesses from making price hikes stick. Prices for clothing, new cars, and toiletries, for example, have dropped back after increasing in the summer. Prices for goods, excluding food and energy, fell 0.1% in October.

However, while retailers are marking down items in an attempt to move inventories out the door, they will not be ordering very heavily from manufacturers. Already, the buildup of inventories appears to be taking a toll. Factory orders fell in both August and September, and industrial production has been flat since July, after rising 0.7% per month during the four previous months.

Production in the nation's factories, utilities, and mines was unchanged in October, following a 0.2% gain in September and a 0.1% decline in August. Output in manufacturing was also flat last month. Going into the fourth quarter, industrial output was barely above its third-quarter level. And the industrial operating rate fell from 79.8% in September to 79.6% in October.

The outlook for manufacturing gains in coming months is not good. In addition to the slowdown in domestic demand, foreign shipments are slipping as well. Although exports rose by $1 billion in September, to $34.4 billion, that was only their second increase in the past five months. Exports are no higher than they were in April.

Factories must also deal with America's insatiable appetite for imports. They rose even more than exports in September, widening the trade deficit to $6.8 billion, from $6.5 billion in August. A lot of domestic demand continues to bypass U. S. producers.

The immediate problem for manufacturers, though, is that the production of consumer goods, up 0.3% in October, has gotten far ahead of demand. Since April, output has risen at an annual rate of 8%. Auto makers accounted for much of that rise, but housing-related durable goods and nondurable goods alike contributed to the growth as well. During the same period, however, real retail sales have grown at a pace of only 1.5% (chart).

That divergence makes it easy to see why retailers are getting into an inventory problem. Getting out of it is likely to cost the industrial sector, and the economy, plenty -- and at a time when this sputtering recovery can least afford it.

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