The Yearend Sprint Hasn't Winded The EconomyBy
Just how strong is this economy, anyway? Judging by the December data, the growth rate at the end of 1993 may have exceeded even the robust expectations of most economists. And while the severe weather may cool off some of the January numbers, there is every indication that the economy carried much of its yearend momentum into the first quarter of 1994.
Several monthly indicators that relate closely to real gross domestic product posted stunning gains last quarter. After adjusting for inflation, retail sales, construction spending, and capital-goods shipments each grew at double-digit annual rates. And manufacturing output posted the largest increase in 10 years.
All this suggests that fourth-quarter GDP growth, to be released on Jan. 28, could be well above the current median expectation of 4.8%. One obvious plus will be healthy fourth-quarter profits. Also, the monthly data indicate steady growth through the quarter, so several GDP components will start the first quarter well above their fourth-quarter levels.
The Federal Reserve's Jan. 19 assessment of economic activity by region, covering the period from December to early January, echoed the economy's more upbeat tone. The Fed reported that consumer spending was "strong" and housing activity "grew robustly," while also noting improvement in manufacturing and credit demands.
But there's a downside. The economy's zip is raising questions about inflation, interest rates, and Fed policy. Given rising commodity prices, increasing demands on industrial capacity, and tighter labor markets, will faster growth fuel wage and price pressures? Will the bond market sour, pushing long-term interest rates even higher? And will the Fed be quick to hike short-term rates?
The December data on retail sales and industrial production leave little doubt about the economy's vitality (chart). Retail buying rose a surprisingly strong 0.8%, following revisions showing a 0.3% gain in November and a 2% surge in October, which turned out to be the largest monthly advance in four years. As in previous months, durable goods led the December increase.
For the quarter, real retail volume appears to have risen at an annual rate of slightly more than 10%, compared with the third quarter. That's about the same gain as the one racked up in the fourth quarter of 1992, which was the largest in more than six years.
The early-bird signs for January consumer spending look good. The Johnson Redbook Report's survey of department stores shows sales in the first two weeks of the month up strongly from December. And the University of Michigan's preliminary read of consumer sentiment points to another increase in household optimism.
Strong consumer buying explains last quarter's pickup in industrial production. Output at manufacturers, utilities, and mines rose 0.7% in December. Production in manufacturing alone was also up 0.7%, led by gains in car and truck output and production of business equipment. For the quarter, factory output rose at a hefty 8.7% annual rate, with motor vehicles and parts accounting for about half of that gain.
The combination of rising demand and low inventories sets the stage for further output increases this quarter. Inventories held by manufacturers, wholesalers, and retailers rose 0.6% in November, a plus for fourth-quarter GDP, but business sales jumped 1.1%. As a result, the ratio of stocks to sales fell to 1.44 in the month--the lowest in more than 12 years. This ratio suggests that some inventory replenishment is necessary, and that will support production gains this quarter.
Moreover, foreign trade appears to have exerted little, if any, drag on growth during the last quarter. The merchandise trade deficit shrank slightly in November to $10.2 billion, from $10.9 billion in October. Exports fell 0.1%, to $40.1 billion, while imports dropped a steeper 1.5%, to $50.2 billion, reflecting a sharp decline in oil prices. Adjusted for prices, the trade deficit has flattened out since the third quarter (chart).
The key question: Is the economy growing too fast to keep inflation down? To begin with, despite the economy's big fourth quarter and its forward momentum, growth in the first quarter seems likely to slow down closer to 3%, the expected pace for all of 1993. One reason: Consumer spending on durable goods, which helped fuel the fourth quarter, is unlikely to match last quarter's pace.
That's particularly true because housing gains are probably close to topping out, given that mortgage rates have stopped falling, that mortgage applications for home purchase are declining, and that the spending boost from mortgage refinancings is waning. Also, first-quarter car production, while scheduled to rise, is slated to do so at a much slower pace than last quarter's.
Despite stepped-up growth last quarter, the December consumer price index showed further signs of inflation's ongoing decline. The CPI rose 0.2% last month, while the core index, which excludes energy and food, increased 0.3%. For the year, inflation fell to 2.7%, down from 2.9% in 1992. More important, the core rate, a better reading of inflation's underlying trend, ended the year at 3.2%--the lowest since 1972.
Most of last year's slowdown occurred in goods prices (chart). Core goods prices rose only 1.6% in 1993, while core service prices were up 3.7%. In particular, apparel prices rose only 0.9% last year, including a 0.7% drop in December. Because of that deep discounting, many retailers may not share in last quarter's profit bonanza.
Looking forward, there is little danger that goods prices are about to speed up. True, industrial capacity utilization rose to 83.5% in December, the highest rate in 4 1/2 years. That's close to the rate that has been associated with past production bottlenecks and price pressures.
However, that rate might be overstated. The Federal Reserve's numbers show industry's capital stock rising only 1.6% during the past year. That just doesn't square with last year's surge in business investment in new equipment, estimated at a gain of 15% to 20%. The Fed has said that it intends to improve its estimate of capital stocks, set to show up in the January report due on Feb. 15, so operating rates may be revised down.
With no clear signs of capacity shortages, the recent rise in commodity prices is not worrisome. It simply reflects the pickup in industrial activity, and it is unlikely to generate faster inflation at the manufacturing level. That's especially true because raw materials account for less than one-third of production costs, while employment costs contribute more than two-thirds.
On that front, labor costs are hardly inflationary right now. The 8.7% advance in factory output last quarter was accompanied by a 3.6% rise in hours worked, suggesting a 5% surge in productivity (chart). Manufacturing productivity for all of 1993 appears to have risen near that pace. With wages growing 2.9%, that means unit labor costs dropped about 2% last year.
Will all this convince the bond market that it has nothing to fear from inflation? Of course not. Right now, the bond market is using strong economic growth as a proxy for inflationary pressures, and as long as the economic data look strong, the more likely it is that long-term interest rates will rise.
But where does all this leave the Fed? While the central bank may not be concerned about inflation in 1994, its focus is on 1995 and beyond. Given the economy's pep, it looks increasingly likely that the Fed will take out a little inflation insurance sooner rather than later. If fourth-quarter GDP growth is surprisingly strong, a hike in the federal funds rate might be only weeks--not months--away.