Just What The Doctor Ordered: Slower Growth

For months now, the financial markets have been terrified that the U.S. economy is on a growth rampage and that faster inflation is inevitable. But whether or not the markets choose to believe it, the latest data strongly suggest just the opposite: The economy is, in fact, losing steam.

The loss of momentum is showing up in two key sectors: consumer spending and manufacturing. In particular, the first signs that higher interest rates are crimping housing are starting to crop up. And the rising trend of unemployment claims suggests that job growth this summer is set to slow from its rapid pace in the spring.

Hold on. There's nothing to worry about. A slowdown in growth from the 7% sprint at yearend 1993 to a more sustainable pace would be a positive development that would limit further rate hikes by the Federal Reserve. And when Wall Street finally notices, the financial markets, even the moribund bond market, should perk up.

Of course, in recent weeks, nothing has been able to pierce the bond market's armor. A small upward revision to first-quarter growth in real gross domestic product, from 2.6% to 3%, was enough to send the U.S. bond market into another tailspin, pushing long-term interest rates even higher. That, plus worries that rapid money growth in Germany will stymie further rate cuts by the German Bundesbank, also took a heavy toll on European bonds.

Never mind that the driving force behind the upward revision was a quirky, and completely unexpected, turnaround in federal nondefense outlays. They were originally reported to have dropped at an annual rate of 7.6%, but now, they show an 18.3% surge--a swing of $7 billion, without which GDP would have been revised down.

But that's history. What about the second quarter? Growth this quarter isn't shaping up to be much faster than it was last quarter. The biggest reason is a slower pace of consumer spending. During the past year, real outlays for goods and services have grown 4%, far ahead of the 2.6% pace of real aftertax income. That pattern cannot hold, especially with the refinancing windfall now largely exhausted and with interest rates on the rise.

First-quarter growth in consumer spending was revised up from a 3.8% annual rate to a 4.6% pace, marking the third-consecutive quarter that outlays have risen close to a 4.5% rate. However, spending tanked in April, falling an inflation-adjusted 0.4%. That was the result of a bigger tax bite on the wealthy (chart), an early Easter that drew sales into March, and some impact of rising rates.

That means second-quarter outlays, so far, are growing at an annual rate of only 0.8%. Spending for the quarter is likely to grow at only about half of the first-quarter pace, or less. That's because May consumer buying looks weak as well. Seasonally adjusted sales at department and chain stores in May dropped a steep 2.6% from April, according to a survey by the Johnson Redbook Report. Auto sales appear to have plateaued. And consumer confidence in May slipped a notch.

Rising interest rates and continued job worries resulted in a decline in the Conference Board's index of consumer confidence to 87.6, from 92.1 in April (chart). Households gave a decidedly more downbeat assessment of their current situations, and a third of the respondents reported that jobs were "hard-to-get," up from 29% in April.

That assessment, plus the rising trend of first-time claims for unemployment benefits, suggests that the rapid pace of job growth in March and April will not be maintained in coming months. Ignoring the weather-related jump in layoffs last winter, the four-week average of new claims in mid-May has increased to the highest level in a year and a half. Employment growth should remain solid, just not as brawny.

It had better hold up. Consumers are more dependent than ever on income growth to support their spending. In April, personal income rose 0.4%, following March's 0.6% advance. Rising wages and salaries, reflecting more jobs and a longer workweek, accounted for about half of the April gain.

However, after higher prices and taxes, real disposable income, which is more closely correlated with spending, dropped 0.5%. Tax payments jumped a hefty $35 billion in April, much of which came out of household savings. Savings as a percentage of disposable income dipped to a skimpy 3.5% in April. During the past half year, the savings rate has averaged only 3.7%, the lowest for any six months in 41/2 years. That's so puny that consumers are likely to use some of their income gains in coming months to rebuild their nest eggs, which will leave less income for the shopping malls.

At the same time, higher interest rates are slowing housing demand and purchases of home-related durable goods, two sectors that were big contributors to growth last year. In fact, higher rates may already be taking a toll. Sales of new single-family homes dropped 6.8% in April to an annual rate of 683,000 (chart), and the nation's homebuilders report that buyer traffic in May was off sharply from its December peak.

With 30-year fixed-rate mortgages averaging 8.68% in late May, according to HSH Associates, and with new mortgage applications falling, weaker sales are not surprising. Mortgage rates are up nearly two percentage points from their October lows, a rise that adds about $140 to the monthly payment on a $100,000 mortgage. That's enough to present a big hurdle for some potential home buyers, especially first-timers.

In fact, home buying may have peaked already. April sales were slightly below the first-quarter average, which was well below the strong fourth-quarter showing. Still, sales might make one last stand. The University of Michigan's May consumer survey of home buying conditions showed a surge in households who think it's a good time to buy in advance of rising rates. But even if that demand materializes, housing should be a drag on second-half economic growth.

In the face of higher interest rates and slowing domestic demand, manufacturing activity seems destined to taper off, as well. Already, factory orders for durable goods, which are especially sensitive to interest rates, dipped in April. Moreover, the National Association of Purchasing Management reports that industrial activity in May leveled off (chart).

The purchasing managers' index stayed at 57.7% last month, no higher than it was back in January. Although the NAPM's price index rose to 71.5% from 63.2% in April, which sent the bond market into another tizzy on the morning of June 1, the index of new orders fell, and the production index fell for the second consecutive month.

Auto makers and parts suppliers are likely to see the sharpest cutbacks in the second quarter. According to vehicle production schedules, the seasonally adjusted annual rate of May output, to be reported in the Federal Reserve's summary of May industrial output on June 15, will be down considerably from the April rate. That drop would also have an impact on parts suppliers, and it would exert a major drag on second-quarter industrial production and on real GDP growth, as well.

Clearly, the economy is not in any recession danger from rising rates, at least not yet. In fact, if the growth slowdown continues to emerge amid further signs that inflation isn't even on the radar screen, the combination would be just the tonic that the financial markets are craving. In particular, it might even bring the bond market out of its funk and set the stage for lower long-term interest rates. And in the longer term, swapping slower growth for lower long rates could extend the life of the expansion.

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