The Rebound Isn't Stalled. It's On Cruise Control

The U.S. economy's downshift, now evident in most of the data, was likely even without the Federal Reserve's four taps on the brakes starting back in February. Now, those four hikes in interest rates only assure that the slowing trend will continue. Of course, that's the Fed's goal: to give the economy a smooth trip by avoiding a spike in inflation that could blow a tire and wreck the expansion.

Right now, though, the radials are in little danger. Consumer price inflation remains benign, with the core rate--which excludes food and energy prices--running at the lowest level in more than two decades. And the May readings on retail sales, industrial production, and capacity use point to slower growth that will keep price pressures at bay.

The consumer price index rose just 0.2% in May, and producer prices for finished goods fell by 0.1% last month. The core CPI rose a bit faster, up 0.3%, while core producer prices increased 0.4%. Tobacco and car prices lifted core inflation in May at both the retail and wholesale levels.

Still, over the past year, core inflation remains on a downtrend (chart). Core consumer prices rose just 2.8% in the past 12 months--the slowest inflation rate in 21 years. And producer prices are little changed since last May.

For consumers, the main components of the CPI show few signs that price pressures are starting to build. In particular, medical inflation has come down sharply since its 9.6% pace of early 1990. In May, health-care costs were up 4.6% from a year ago, the mildest hike in 20 years.

The service sector remains the place to look for inflationary stress. But even here, the pressures are few. The one area worth watching is a rise in the price of shelter, the result of healthier housing demand.

The cost of shelter over the past six months has risen at an annual rate of 3.3%, up from 2.6% in the previous six-month period. Since shelter is about 28% of the entire CPI, the pickup suggests that the growth in the CPI may be near the bottom for this cycle. However, the Commerce Dept. data show that consumers devote only about 14% of their spending to housing, suggesting that housing's inflationary impact on the economy as a whole is not that great.

That's not to say the road ahead is clear of price potholes. Because of the Labor Dept.'s new seasonal factors, which softened inflation's sting in the winter, there is a risk of a big monthly jump in the CPI this summer. That one-time gain would likely reverse itself later on, though.

More worrisome is the outlook for oil prices and the dollar. Members of the Organization of Petroleum Exporting Countries began their quarterly meeting on June 15 to set future production quotas, even as energy prices are on the rebound. The spot price for Brent crude oil has risen 18.1%, to $16.25 a barrel, since the end of March, when OPEC last met.

So, too, the weaker dollar exerts upward pressure on the prices of foreign-made goods. That's not an insignificant consideration for an economy that imports about one-quarter of all the nonpetroleum goods it buys. Indeed, prices of nonoil imports, which rose 0.4% in April, are up 2% during the past year, about twice as fast as in April, 1993.

Of course, the May price performance says little about the future of inflation. The latest news from retailers and manufacturers, however, does signal that growth is slowing. That means the economy remains short of the point where strong demand and product shortages lead to a speedup in price hikes.

Industrial output increased by just 0.2% in May, and April's data were revised lower, to show a gain of just 0.1% instead of 0.3%. Manufacturing production rose 0.2% in both April and May (chart), way below its advances in the preceding two months. So far this quarter, total industrial production is growing at a 3.2% annual rate, less than half of its 8% clip in the first quarter.

Auto output fell 3.9% in May, the third consecutive decline as demand for cars and light trucks begins to taper off. Makers of business equipment remain busy, however. Output there rose a robust 0.9% in May, the 23rd consecutive monthly increase.

Companies are investing in new equipment to improve productivity and lower unit-labor costs. Many are succeeding. The Labor Dept. says output per hour worked in the nonfarm business sector rose at an annual rate of 1.3% in the first quarter, higher than the 0.5% increase originally reported. As a result, unit-labor costs grew by 3.9%, instead of a 5% clip.

Clearly, better productivity is another reason to be optimistic about the inflation outlook. It also means that factories can operate at higher capacity-utilization rates without the danger of production bottlenecks. Industry used just 83.5% of its available capacity in May, down slightly from 83.6% in April.

Any increase in operating rates, as well as future output gains, will be tempered by the conservative management of inventories so far in this expansion (chart). Inventories at factories and wholesale- and retail-trade companies rose 0.2% in April, as sales fell 0.8%. However, the ratio of inventories to sales edged up only a bit from its record low of 1.39 in March, to 1.40 in April.

The slowdown in consumer spending will also keep industrial production growing at a modest pace in the second half of 1994. In May, retail sales fell 0.2%, on top of a revised 1.1% drop in April (chart).

The May decline occurred entirely at car dealerships, where receipts slipped 1.9%. Excluding autos, sales rose 0.3%, hardly reversing the 0.7% fall-off of April. Furniture buying remained strong in May, rising 1.7%. Demand for home-related durable goods will start to slow this summer, though, as the increase in mortgage rates bites into housing.

So far in the second quarter, retail sales adjusted for inflation are about flat with their average of the first quarter, when they grew at a fast 5.4%. But the latest news for June shows that stores were a bit busier this month.

Johnson Redbook Report, published by Lynch, Jones & Ryan Inc., says sales at department and chain stores rose 3.6% in the first two weeks of June from May. That's much more optimistic than the chain-store sales index compiled jointly by Mitsubishi Bank Ltd. and Wertheim Schroder & Co., which shows sales up 0.8% in the same period.

Moderation in consumer demand is crucial to the downshift in overall growth. Clearly, slower job growth is not welcome news for those who are out of work, and some companies may suffer from the drop in business. But for the U.S. economy as a whole, cruising in third gear is a lot better than driving into a ditch while trying to dodge inflation.

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