Sure, It's A Tortoise Recovery. That's What's Good About It

In the race toward recovery, the economy is playing the tortoise, not the hare. Growth is slow but steady. In coming quarters, that kind of business environment is bound to be frustrating as the economic data continue to lack the verve associated with past rebounds. But over the long haul, this slowpoke could be a winner, because modest growth will prolong the recovery by keeping upward pressure off inflation and interest rates.

No one would be happier with that outcome than the policymakers at the Federal Reserve. And the Fed's June 17 survey of business conditions points to just that scenario. The results show that "economic activity continued to improve" in May and early June and that "price stability in the retailing and manufacturing sectors seems to be the rule" across the nation.

Unlike last year, though, growth is not so slow that companies can't feel it. A better assessment of current conditions boosted confidence among U.S. executives in the second quarter to the highest level since 1984, says the Conference Board. And Dun & Bradstreet Corp. reports that business expectations for third-quarter sales are up sharply, to their highest point in three years.

Manufacturers are especially upbeat, says D&B. That makes sense. Demand has perked up, reflected in rising commodity prices and factory orders. Inventories are very lean. And fatter factory payrolls this summer are a good bet, because output is already picking up.

Industrial production at factories, utilities, and mines rose 0.6% in May, the fourth consecutive gain. Factory output alone jumped 0.7%. Both gains were the largest in 10 months. Industrial production is now at its highest point in about a year and a half (chart).


Manufacturers can thank autos and housing for their heftier order books and their brighter spirits. Production of cars and light trucks--including minivans and jeeps--rose sharply in April and May, and recent stronger auto sales will support Detroit's ambitious third-quarter output plans. Production of home appliances and furniture also posted healthy gains, and more increases are on the way.

That's because the housing recovery remains on track. Housing starts had tumbled 17.3% in April but bounced back by 11% in May, to an annual rate of 1.23 million (chart). Single-family starts alone rose by 9.8% in May, after dropping 10.9% in April. The May gains relieved some of the worry, caused by the April plunge, that the housing recovery was running out of steam.

The latest survey from the National Association of Home Builders also indicates that housing is in good shape. Although the June readings on home sales and buyer traffic slipped from May's high levels, both measures are far above their levels of last year, and the sales outlook for the next six months remains positive.

One reason for optimism is falling mortgage rates. The average rate on a 30-year fixed mortgage dropped to 8.61% in mid-June, the lowest level since January.

Of course, when people buy new homes, they need to furnish them. The housing recovery is a big reason why retail sales continue to climb. Sales rose 0.2% in May, after a 0.4% gain in April. Increased purchases at car dealers and furniture and department stores offset declines elsewhere in May.

Car dealers remained busy in early June. U.S.-made cars sold at a 6.5 million annual rate in the first 10 days, up from 6.3 million in May and 6 million in April. And light trucks sold at a hefty 4.7 million clip in early June.

Increased buying of cars and trucks could mean another gain in retail sales this month. Slow job growth, however, is keeping this quarter's gains in consumer spending at a much more modest pace than in the first quarter. So far in the second period, retail sales are no higher than their average of the first quarter, when they surged at an 11.2% annual rate.


Still, the rise in consumer spending is spurring retailers to restock their shelves. Total inventories held by manufacturers, wholesalers, and retailers rose by just 0.1% in April. But broken down, the data show that retail stock levels jumped 1.1%, while factory and wholesale inventories declined.

Recent growth in retail sales and inventories have not entirely benefited American producers, though. That's because imports are taking an increasing share of retail dollars. In general, the yearly growth in imports of nonauto consumer goods follows the combined pace of retail sales and inventories. But since mid-1991, imports--up some 19% over the past year--have grown far faster than nonauto retail activity, which is up just 3.7%.

Rising imports will lessen the growth in real gross domestic product in the second quarter. However, foreign competition is one of many reasons why inflation this year will remain very tame.


The subpar recovery is the main reason why inflation will stay modest. Price pressures will build more slowly than they would if the rebound was closer to the average postwar experience. That means the Federal Reserve will have more freedom to keep interest rates down as the upturn progresses. And any Fed tightening will begin much later into the recovery.

To be sure, the Fed isn't likely to hike interest rates anytime soon, out of fear that inflation needs some restraint (chart). The business climate remains clearly disinflationary. From the demand side, a lackluster economy means that the pace of jobs and incomes--and thus consumer spending--is only modest. And the growth of money and credit remains sluggish.

On the cost side, wage growth is slowing down, and productivity gains will further retard the growth of unit labor costs. Output per hour in nonfarm industries rose 2.7%, at an annual rate, in the first quarter. Combined with the 2.2% rise in wages and benefits, the productivity gain means that unit labor costs fell 0.5%.

As productivity posts its typical recovery pickup, the labor cost of producing a unit of output will continue to grow slowly. During the past year, unit labor costs have risen a mere 1.2%--the slowest yearly growth in eight years and well below the pace of retail prices. Modest gains in unit costs mean that businesses will be able to enjoy fatter profit margins without generating upward pressure on prices.

Also, plenty of industrial capacity remains idle. The operating rates for all industry rose to 79% in May, up from 78.7% in April. However, capacity in use is no higher than it was a year ago (chart). And it is still well below the rate of about 83% that is typically associated with supply conditions conducive to price hikes.

The latest price indexes reflect this disinflationary environment. The producer price index for finished goods rose 0.4% in May. The core PPI, which excludes energy and food, was up 0.6%. However, one-time jumps in prices of tobacco products, up 7.3%, and aircraft, up 3%, accounted for about half of both of those increases. Through May, annual inflation in the PPI is running at only 1.2%, and the core rate is 2.8%.

The news from the consumer price index is more encouraging. The CPI rose a scant 0.1% in May, and excluding food and energy it was up a modest 0.2%. During the past year, consumer price inflation has fallen to 3.1%. And the core rate is ensconced below 4% for the first time in five years. That suggests fundamental, not transitory, improvement.

In fact, some of inflation's toughest areas are showing moderation. Price growth in services, for example, exceeded 6% in early 1991. Now, it has fallen to 4.1%. Even costs of medical services are slowing down.

A modest recovery that will slowly bring down the jobless rate while keeping pressure off inflation seems to be the Fed's goal. So far, this tortoise economy continues to crawl forward. But if the central bank decides that it needs a prod, low inflation will give the Fed the leeway to nudge interest rates another notch lower.

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