The Economy Is Plenty Warm Beneath The Ice

If you're suffering from a severe case of cabin fever, you're not alone. The onslaught of ice, snow, and cold has made this winter the most maddening in recent memory--even without the excessive churning of the Harding-Kerrigan soap opera.

Earlier this quarter, the first few storms showed little effect on the economy. Now, however, after 12 storms along the East Coast, business activity is frostbitten, especially in retail trade and housing. Last month turned out to be the 15th wettest and third coldest January in the last 99 years, according to the Commerce Dept.

But while the duration of the harsh weather may be curtailing some economic growth this quarter, the underlying fundamentals are still sturdy. In fact, Dun & Bradstreet Corp. reports that business expectations for first-quarter sales and profits rose a bit from the fourth quarter. Manufacturers were especially upbeat. And the National Federation of Independent Business says optimism among small-business owners jumped in January. All this suggests that the economy will bounce back when the weather returns to normal.

The weather, however, has already taken its toll on retailers and builders. Retail sales fell 0.5% in January--derailing a string of nine consecutive increases--and housing starts plunged 17.6% (charts). The retail losses were evident in weather-sensitive areas such as building materials, restaurants, and auto dealers.

The good news for the economy is that the drop in retail sales does not mean consumer spending is falling this quarter. December buying was revised sharply higher, meaning that sales began the first quarter above their fourth-quarter average. Also, demand for services--from utility use to emergency-room visits--is experiencing a weather-related gain.

In addition, consumers will eventually buy most of what they didn't purchase in January. However, the continued bad weather in February suggests that this postponed spending will come later in the first quarter. The Johnson Redbook survey of department and chain stores shows that sales in the first two weeks of this month were down 1.8% from January.

So, too, the drop in housing starts is a temporary setback. Starts plummeted to an annual rate of 1.29 million in January, the lowest since July and the largest decline in a decade. Starts tumbled 33% in the Northeast, 22% in the South, and 23% in the Midwest.

The latest news from mortgage bankers and realtors shows that housing activity will rise as soon as the temperatures do. Home-mortgage applications hit a record high in early February, and housing affordability also was the best on record in the fourth quarter. The continued strength in housing demand explains why permits to begin new construction in January fell by just 7.9%, far less than the decline in actual starts.

Even when the weather becomes more hospitable, though, the economy may face more turbulence. The new wrinkle is a weaker dollar. After the disastrous trade summit between President Clinton and Prime Minister Morihiro Hosokawa on Feb. 11, the dollar plunged 4% against the yen on Feb. 14, to 102.25, before rebounding to 103.80 yen on Feb. 16.

One threat to the U.S. economy from all this is in the financial markets. Bond traders are worried that the Japanese may dump their holdings of dollar-denominated assets, especially U.S. Treasuries. That would depress bond prices, and push up long-term interest rates.

Moreover, the dollar fell against all major currencies, not just the yen. The Federal Reserve, which has already hiked interest rates once, now faces the inflationary potential of a weaker dollar. Fears of higher short-term rates are already lifting long-term yields, and a further rise in long rates will hurt the economy much more than the drag from our $60 billion trade deficit with Japan.

Nature's fury also buffeted the nation's factories in January. The weather, plus the California earthquake, substantially limited output growth last month, especially in steel, appliances, and motor vehicles, according to the Federal Reserve's report on industrial production. However, rising orders and low inventories mean sturdier output gains in the coming months.

Mother Nature distorted the January output data in opposite directions. Overall industrial production at factories, utilities, and mines rose 0.5%, but manufacturing output alone increased a slim 0.2%, after gains averaging 0.9% in the fourth quarter. At the same time, a burst of demand for heat boosted utility production by 3.5%.

The momentum that manufacturing developed last quarter should reassert itself in coming months, with continuing lifts from housing-driven demand for consumer durables, strong vehicle sales, and the investment boom in high-tech equipment. Business-equipment output still jumped 1.3% in January, despite the weather.

In addition, auto and truck production is set to increase strongly. Carmakers have upped their February and March plans, more than making up for lost time in January.

A big plus in the outlook for factory output is very low inventories, especially in manufacturing (chart). Total stock levels of manufacturers, wholesalers, and retailers were unchanged in December, but business sales rose 0.8%.

That combination pulled the ratio of inventories to sales down to 1.43--the lowest in the 13-year history of the data. Even after adjusting for inflation, the real ratio is at a five-year low. And because bad weather hit both sales and output in January, weaker retail buying last month is unlikely to cause an inventory overhang that would cut into new orders.

The really good news in the factory sector's outlook, however, is that its momentum is not generating worrisome pressures on inflation.

For example, the producer price index for finished goods rose only 0.2% in January. The core PPI--excluding energy and food--increased a faster 0.4%, but unusually large one-month advances in tobacco and car prices accounted for half of the rise. The annual inflation rate for both indexes is about zero.

Moreover, it may stay there for a while, even as capacity utilization rates creep toward the point where production bottlenecks have generated price pressures in the past. The industrial operating rate climbed to 83.1% in January from 82.9% in December, while the rate in manufacturing dipped to 82.1% from 82.2%, reflecting the output weakness caused by the cold and the quake.

However, industry has a bit more idle capacity than previously thought. The Federal Reserve estimates that production capacity has grown slightly faster than in its earlier reports, resulting in a downward revision in the capacity utilization rate (chart). For example, the new rate in manufacturing in December is 0.5 percentage point lower than before. And because of the ongoing surge in equipment investment, available capacity may still be underestimated.

More important, though: Operating rates are becoming increasingly unreliable as a guide to nascent price pressures. Stunning productivity growth in manufacturing in recent years allows higher U.S. rates of capacity use without generating inflation. Also, there remains plenty of idle capacity abroad, including foreign operations of U.S. companies. All this suggests that the inflation flashpoint for operating rates, historically in the 83%-to-85% range, is now higher than it was before.

So as you cuddle up on the sofa watching Tonya and Nancy, and waiting for deliverance from this never-ending winter, here's one thought to keep you warm: Even as the economy begins to thaw out in coming months, inflation should stay frozen.

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