Why This Rebound Has So Little Oomph

This sloth of a recovery is starting to get on people's nerves. With only 18 weeks until the Presidential election, the White House is yelling at the Federal Reserve to cut interest rates. The Fed is bickering within itself. Households, facing heavy debts and light wallets, are pointing fingers at both crews. And businesses, after slashing costs and lifting productivity and profit margins, are all revved up with no place to go.

Disappointing data on home sales, jobless claims, factory orders, and retail sales have only heightened the tension. More recently, the nation's purchasing managers say that growth in the industrial sector slowed in June. The leading indicators, up 0.6% in May, point to recovery but not as convincingly as they typically do early in an upturn. And the index of coincident indicators, which tracks the economy in the here and now, shows hardly any sign of recovery at all (charts).

In fact, economists increasingly believe that another cut in interest rates--perhaps a bold one--is justified to assure the recovery's survival. The present combination of economic torpor, an undeniably tranquil inflation outlook, and the listless behavior of money and credit gives the Fed a powerful call to action.

Wait a minute. Fed easing? Economic torpor? What kind of recovery is this anyway? The quick answer is, painfully slow. The economy grew 2.7% in the first quarter, and it was struggling to match that pace in the second quarter. First-half growth is half the norm for past upturns, and it is hardly fast enough to bring down the jobless rate. Clearly, the rebound is shaping up to be the weakest in the postwar era.


Why? First and foremost, the Fed has made it clear by both word and action that it wants a moderate recovery that will keep pressure off inflation. As long as the budget deficit freezes the option of fiscal stimulus, the central bank has the only policy game in town, and it can maneuver interest rates to get what it wants.

The Fed's policy committee sat down on June 30 and July 1 for its last meeting before Chairman Alan Greenspan goes to Capitol Hill in late July for his twice-yearly report on monetary policy. If the Labor Dept.'s job numbers, released on July 2, paint a sufficiently drab picture of the economy, analysts are betting that the Fed will put its internal disagreements aside and ease sometime before Greenspan's testimony--and that banks will respond by cutting their prime rate from 6 1/2%.

But despite the fall in short-term interest rates, the Fed has been unable to effect a commensurate drop in long-term rates. With a flood of Treasury debt washing over the credit markets, traders worry about the potential inflationary consequences of all that paper, and they demand higher yields to protect against possible losses.

As a result, the yield spread between long- and short-term Treasury securities is the widest in more than three decades. Lower long rates are critical to housing and other big-ticket purchases, but more important, they speed up the reliquification of debt-burdened households.


Right now, that process isn't going too well, and a healthy consumer sector is paramount for a solid recovery. Despite the drop in installment debt outstanding, heavy mortgage obligations are keeping total household debt as a percentage of aftertax income near a postwar record. The yearly growth rate of consumer IOUs has fallen to only 4.2%, the slowest pace on record, but household assets are rising at less than half that pace, according to economists at Merrill Lynch & Co.

The folks at Merrill also point out that inflation will not be around to help bail out consumers by eroding the real value of their debt. In the past, faster inflation allowed consumers to pay back loans in dollars that were worth less than the ones they borrowed. On top of all this, slow income growth and low savings mean that household reliquification will be a drawn-out affair--and that will weigh heavily on spending.

Consumers bought at a normal recovery pace of greater than 5% in the first quarter, but their financial foundation has not improved rapidly enough to maintain such heady growth. Real consumer outlays, adjusted for inflation, rose by 0.2% in April and 0.3% in May. Stronger car sales in June and the large response to cut-rate airfares suggest that buying rose by a similar amount last month. But even with another healthy gain, real spending probably rose at an annual rate of barely 1% in the second quarter.

Because households remain wary about taking on more debt, income gains will largely determine this year's pace of buying. Last year, growth in real aftertax income ground to a halt during the second half, causing the recovery to poop out. So far this year, incomes are growing sufficiently to generate a spending recovery, but don't expect any speed records. Real income rose 0.1% in May, after dipping 0.2% in April, and in the first half, it grew at an annual rate of about 2.5%.

Falling interest earnings, nearly 14% of household income, are an unusually heavy drag on this recovery. Personal interest income is in its steepest slide on record. During the past year, real aftertax income has grown 1.7%. But if it had not been for a 9% plunge in real interest earnings, real income would have been up by 3.8%.

Incomes apparently are growing fast enough to keep consumers in a relatively upbeat mood. The Conference Board reports that its index of consumer confidence stood at 71.7 in June, slightly below the 71.9 level of May, but still a high reading. Households' feelings about the future are optimistic compared with their mopey attitudes earlier this year (chart). The board notes that the Presidential campaign may be unsettling, but it says the big worry remains job prospects.


Unlike past recoveries, job growth in this upturn is unusually slow. A big reason is cost-cutting and restructuring, particularly by service companies. Service producers generate four-fifths of all payroll jobs, but so far this year, service employment has risen by only 70,000 jobs a month. That's about half the pace of past recoveries. The past recession was different in that workers weren't just temporarily laid off. Many jobs, especially white-collar positions, were permanently eliminated.

Slow growth in jobs and incomes, along with high long-term interest rates, makes a tough climate for housing. Moreover, much of the recent gains in consumer spending have been related to the year-long housing recovery. And that's why the recent softness in home buying is so troubling.

Sales of existing homes dropped 1.7% in May, and purchases of new single-family homes fell by an unexpectedly large 5.6% in May, to an annual rate of 501,000. That was the fourth decline in a row--something that hasn't happened since late 1990. Sales in the West were especially weak. They dropped by a record 34.4%, to a 105,000 pace--the lowest in 10 years. That looks like an aberration, however. June sales in the West are likely to bounce back, giving a boost to the national data.

More important, home sales will get some help this summer from falling mortgage rates. The average rate on a 30-year fixed mortgage has dropped from 9.08% in March to 8.52% in late June. That's the lowest rate since January (chart). Indeed, the lackluster showing in May may have reflected the spike in rates in March and April. That's because consumers are unlikely to bid on a home when rates are rising, and the sales data count only home sales that are actually closed--which usually happens one or two months after the initial bidding.

The list of depressants on the recovery also includes defense cuts and the interrelated problems of sour real estate deals and many financially fragile banks. When you add everything up, you get an unprecedented burden for an upturn to carry. However, there is nothing in the data to suggest that the economy is not up to the task. It's just going to be a slow--and frustrating--trip.

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