The Fed's Hikes Won't Faze Factories Much

The U.S. factory sector may feel like the lucky student who can hide behind the tallest kid in the class when the teacher is looking for a few knuckles to rap. Manufacturing has long been the Federal Reserve's whipping boy when it comes time to slow down the economy. But this time, factories may avoid much of the pain of this year's round of interest-rate hikes.

Undoubtedly, higher borrowing costs will curtail housing and some factory activity, especially in consumer durables such as furniture and appliances, which are typically bought on credit. But long-term interest rates have been rising since October, and the industrial sector has been going like gangbusters for two quarters.

Indeed, output of manufacturers, utilities, and mines increased by 0.5% in March, the 10th consecutive advance. Factory output alone rose a stronger 0.6%, despite a slowdown in auto production, after Detroit's torrid pace in February. For the first quarter, factory output grew at a 7.8% annual rate, on top of an 8.4% gallop in the fourth period (chart).

Looking ahead, a moderate pace in consumer and business spending, along with the need to rebuild inventories, will support the industrial sector this year. The latest survey by the National Association of Manufacturers shows growing optimism among small manufacturers. The NAM says 70% of small companies see sales "increasing substantially." And if export growth pumps up the second half, as is expected, production will show even more muscle.

Amid this growing momentum, the Fed executed its third quarter-point hike in the federal funds rate in 11 weeks on Apr. 18, to 3.75%. The action rocked the recently quiet financial markets with a surprising pickup in the speed of monetary tightening. In response, commercial banks lifted their prime rates by a half-point, to 6.75%, and stock and bond prices plunged.

But despite manufacturing's dynamism, the timing of the Fed's move probably came in response to other factors. First, the financial markets had calmed down following past rate hikes. Also, no new economic data were released that day, so the Fed's move appeared preemptive and not in reaction to strong numbers.

Moreover, the hike, made at Fed Chairman Alan Greenspan's discretion between policy meetings, reinforced the Fed chief's leadership role after the press reported that he may be losing influence on the policymaking committee. Most Fed-watchers had pegged the next rate rise to the May 17 policy meeting. Now, that is the most likely date for the Fed's fourth hike, probably including an increase in the discount rate, currently at 3%.

After that, however, the pace of tightening may slow. One reason: First-quarter growth in real gross domestic product appears to have been less than the markets had feared. That's because the huge widening in the February trade deficit suggests that trade alone subtracted more than one percentage point from last quarter's growth.

The Fed's action was clearly an acknowledgment of the strength in manufacturing and the resulting rise in capacity utilization--usually a warning of faster inflation. Operating rates for all industry rose to 83.6% in March, from 83.4% in February. Manufacturing used 82.8% of its capacity in March, up from 82.5%. Several industries, including steel, computers, and paper, operate above 90%.

Are those high operating rates inflationary? Not necessarily. Greater worker productivity means more output is being created with the same amount of capacity. And U.S. businesses are planning to invest heavily in new plants and equipment this year. Meanwhile, global outsourcing is still a safety valve when capacity is under pressure in the U.S.

The rise in long rates will have its most conspicuous impact on the housing sector and its suppliers within the manufacturing sector. Higher mortgage rates hit just as construction costs began to rise. For now, buyers are flocking to open houses and rushing to lock in rates.

Housing starts in March rebounded further from their weather-depressed January level. Starts jumped 12.1% to an annual rate of 1.47 million, following a 3.4% gain in February. Still, those increases hardly recouped January's 21.2% plunge (chart). For the quarter, starts are 8.3% below the fourth-quarter. Homebuilding will continue to increase in the spring and then taper off as demand wanes.

That's how homebuilders see it. The percentage of builders who expect "good" sales in the next six months fell sharply in April, to 38%, according to the National Association of Home Builders. That's down from 48% in March and 72% in November.

Fewer housing starts this summer will mean a slowdown in the production of building materials, appliances, and other home-related goods. Even before housing's contribution to the gross domestic product begins to diminish, however, inventory rebuilding may take its place of a source of growth.

Indeed, when compared to sales, business inventories have almost never been lower. In February, inventories at factories, wholesalers, and retailers rose 0.5%, but sales jumped 1.2%. Manufacturers' stock levels rose 0.3%, and sales jumped 1.1%. As a result, the ratio of business inventories to sales is close to its record low of December, 1993 (chart).

With demand still growing, businesses will need to stock more goods. Car dealers already face shortages of some popular models. Inventory rebuilding has not been a sizable contributor to economic growth in this expansion. That may change this year, perhaps as early as the second quarter.

By the second half of this year, manufacturing may also start to see some extra lift from exports, which have been a big disappointment so far in 1994.

In February, a 3.6% drop in merchandise exports, coupled with a 1.6% rise in imports, sharply widened the merchandise trade deficit. It rose to $12.4 billion, from $10.2 billion in January. The trade gap for all goods and services widened to $9.7 billion in February, from $6.6 billion.

The export decline was the second in a row, pushing down price-adjusted exports to their lowest level in six months. Even assuming a bounceback in foreign shipments in March, the deterioration in the trade deficit last quarter appears to have offset a large chunk of domestic demand (chart).

In fact, the healthy pace in domestic demand means that imports will continue to rise at their double-digit rate of the past two years. So any significant improvement in trade will have to come from exports. Export growth has been supported by demand from developing countries. Shipments to Latin America and Southeast Asia in January and February were up 10.3% from a year ago, while total exports rose just 3.7%.

Boosting overall exports, though, will depend on recoveries in Europe and Japan. The problem is that Fed tightening runs the risk of delaying a European upturn by keeping long-term rates in Europe higher than they would otherwise be.

That's because the sell-off in U.S. stocks and bonds has dominoed into foreign markets. When the yield on 10-year Treasury bonds rose by 20 basis points on Apr. 18, the rates on similar German and British securities rose 13 and 27 basis points, respectively. Until Europe's financial markets can decouple from the bearish U.S. market, weak domestic demand on the Continent must suffer yet another drag.

Even if strong export growth doesn't materialize, though, demand here in the U.S. should remain healthy enough to keep industrial output growing and the economy humming. Indeed, unlike past cycles of Fed tightening, a more productive, less inflation-prone manufacturing sector may turn out to be the star pupil of this year's economy.

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