The Economy Is Stronger, But It's Still No Schwarzenegger

Is the U.S. economy finally beginning to show a pulse? Yes. Growth this year has averaged 2.8%, up from only 1.2% during the three previous quarters, and the latest data look brighter. Is the economy ready to expand at the nearly 4% pace indicated by the gain in third-quarter gross domestic product? Don't count on it.

The economy's better showing recently is the result of low interest rates, rising profits, and faster productivity growth. This trio is chipping away at many of the struct-ural barriers that have held growth back for so long. But the problems created by excessive debt, corporate restructurings, overvalued real estate, weak banks, and defense cuts are far from resolved. And the economy will most likely run into them again in coming quarters.

Lately, the data have been showing more muscle than in the summer. But they can hardly be characterized as strong. For example, the index of leading indicators, designed to forecast the economy's direction, rose 0.4% in October, but it remains in a flat trend, no higher than it was in July. The index of coincident indicators, which tracks the economy's current path, also rose, but it, too, shows no upward momentum (chart).

Other numbers from factories, retailers, and homebuilders also have improved recently, but the real attention-getter was the upward revision to last quarter's real GDP. The Commerce Dept. said the economy grew 3.9%, far greater than the 2.7% gain originally reported. That makes third-quarter growth the strongest in nearly four years. But looking deeper, the report is less reassuring than the top-line number suggests.


The GDP report reveals three problems that weigh on future growth: First, the jump in real GDP occurred without any rise in jobs or hours worked in the private sector. That means a robust gain in productivity, but not for household incomes. Consumer spending advanced strongly, but aftertax income did not increase at all.

Second, nonfarm inventories rose last quarter at the fastest clip in two years, but manufacturing output barely increased. Imports appear to have accounted for some of the inventory buildup, but much of it may have been unintended. If so, future production growth will suffer.

Manufacturing does appear to be gaining a little momentum in the fourth quarter, but consumer demand will have to stay firm for that to continue. The purchasing managers' index of industrial activity rose to 55% in November, from 50.6% in October, according to the National Association of Purchasing Management (chart). In September, the index had slipped below the 50% line that divides expansion and contraction in the factory sector.

The NAPM said the overall index in November was the highest since May, as were the readings of the individual components for orders and production. Of particular note, the employment component of the index rose in November, suggesting that the erosion of factory jobs may be moderating.

The third problem that shows up in the GDP report is the trade deficit's growing drain on the economy. Excluding the drag from a wider trade gap, real GDP would have grown at a 3.6% pace so far this year, instead of 2.8%.

That drain will continue. Although exports advanced smartly last quarter, future foreign shipments will suffer from recessions in Japan and Europe. Also, imports will continue to come in at a faster clip, as U.S. growth picks up. This year, the merchandise trade deficit is on track to hit $85 billion, and a recent Treasury Dept. report says the gap could exceed $100 billion in 1993.


The most troubling of the three problems is the divergence in the growth rates of consumer spending and aftertax income. Commerce revised third-quarter consumer spending upward, from an already strong gain of 3.4% at an annual rate, to a 3.7% advance. Even as outlays expanded, though, households' real disposable income rose only 0.4%.

This split calls into question whether shoppers can continue their buying spree. The early reports on holiday shopping are encouraging. But if consumers continue to spend at a faster clip than their incomes grow, a merry Christmas could give way to a dreary New Year.

Incomes did get off to a good start this quarter, but one-shot deals exaggerated the gain. Both personal and aftertax incomes rose 1% in October. Even with a 0.4% rise in prices, earnings were up a hearty 0.6%. That jump, though, reflected a bounce-back in rental income after hurricanes Andrew and Iniki, increased farm subsidies, bonuses to auto workers, and early-retirement payments to Postal Service workers. Excluding these factors, income was up 0.4%, the same pace as inflation.

The gap between income and spending growth is more compelling if you look back six months. From April to October, real consumer outlays rose at an annual rate of 3.4%. That's twice the 1.7% pace of real aftertax income.

Moreover, the special gains that boosted October incomes won't be repeated in coming months, so any significant pickup in income will have to come from growth in jobs and wages. Such gains have been almost nonexistent during the past one-and-a-half years. Excluding government transfer payments, real personal income is no higher now than it was at the end of 1990.

Without sufficient income, consumers have had to tap into their already low savings in order to finance purchases (chart). During the past three months, savings as a percentage of aftertax income stood at 4.6%, down from 5.5% last spring. Consumers have never gone into an economic upturn with such a low savings rate.

The hurricanes also affected consumer spending in October, when real outlays grew by 0.3%. Purchases of durable goods surged by 1.8%, with big spending on furniture, appliances, and building materials. These purchases probably reflected rebuilding from the storms as well as gains in home sales. Although housing activity proceeds in zigs and zags, home buying remains one of the brighter spots in the outlook.

In October, sales of existing homes zigged, while new-home sales zagged. Resales jumped 9.1%, to an annual rate of 3.6 million--the highest level in four years. Sales of new single-family houses dropped by 10.3% for the month, to a 600,000 annual pace, but sales during the past four months have stayed above the 600,000 mark. Home buying hasn't been that strong since 1989.

This healthy pace suggests further spending on home-related items, as well as increased activity in the building industry. Construction spending advanced by 1% in October, after a 1.8% jump in September. Rising outlays for residential building led the increases in both months. In addition to demand for new houses, hurricane rebuilding will keep builders busy in coming months.


The hurricanes not only destroyed homes but also battered corporate profits. Business losses and benefits paid by insurance companies subtracted $42 billion from third-quarter earnings. As a result, pretax book profits fell 7% last quarter. Without the storms, earnings would have increased by 4.2%, to a record high (chart).

Despite the hurricanes, the operating profits of nonfinancial corporations managed a 1.6% rise last quarter. That kept operating profits as a percentage of output at 8.7%, the highest in two years. If businesses had not written off their hurricane-related losses, this margin would have continued its rise of recent quarters. That mainly reflects the slowdown in unit labor costs and the steep reduction in interest payments.

With earnings likely to improve this quarter, profit margins could swell past 10%--a level not seen since 1988. That will help corporations achieve the financial footing to expand payrolls at a faster pace. But companies will have to see a sustained pickup in demand--particularly from consumers--before they are confident enough to add workers. And job growth is what it will take to make this expansion feel like the real thing.

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