Shy Shoppers, Crowded Shelves Spell Slower Growth

Market players are always more interested in where the economy is going than where it has been. But when the Commerce Dept. takes a look back at last quarter's gross domestic product on July 29, including three years' worth of revisions, there might be a message about the future as well.

In general, economists expect growth to have been a shade faster in the second quarter than the 3.4% annual rate of the first quarter. But when the number comes out, check the mix. The monthly data show that overall demand, especially consumer spending, slowed sharply last quarter (chart), and the huge widening in the May trade deficit indicates that foreign trade also was a drag. At the same time, inventories piled up, accounting for a big chunk of the quarter's growth.

That combination could depress third-quarter GDP, as businesses cut back on ordering and output in order to whittle down stock levels. Also, last quarter's big bounce back in construction from the first quarter's weather-depressed levels is not sustainable in the third quarter, in the face of rising interest rates.

No kidding. Housing starts plunged 9.8% in June, to an annual rate of 1.35 million, the lowest level since February, while permits to begin new construction fell for the second month in a row. In July, builder surveys noted declining sales activity, and mortgage applications to buy a home dipped to their lowest level in a year and a half.

The apparent mix of the second-quarter GDP, especially the slippage in demand, is further evidence that inflation will remain subdued. Any immediate rate hike before the Federal Reserve's Aug. 16 policy meeting, as some Fed watchers expect, would be difficult to justify.

Indeed, Fed Chairman Alan Greenspan suggested during his semiannual congressional testimony on monetary policy on July 20 that another rate increase was not imminent. He said that "considerable uncertainty" about future growth and price pressures was voiced at the July 5-6 policy meeting--a reason why the Fed kept rates steady. However, he also said that the Fed's near-term inflation-control efforts may not be complete, leaving the door open for another hike later on.

But if the central bank's latest forecast is on the mark, there will be little need for further tightening. The Fed sees the economy settling into "more moderate rates of growth" through 1995, with inflation remaining "relatively subdued" (table). In fact, if second-quarter growth is about as expected, the Fed's projections imply that real GDP growth in the second half will slow somewhere between 2.6% and 3%.

Consumer spending--two-thirds of GDP--led last quarter's falloff in demand. Retail sales rose 0.6% in June, after declines in both April and May. For the quarter, inflation-adjusted sales posted only a slim gain, part of a progressive slowing since their fourth-quarter free-for-all. Based on the retail data, consumer spending strained to rise at a 1% annual rate last quarter, the weakest advance in five quarters.

Consumers appear to be constrained by a lack of savings, especially now that the refinancing windfall has played itself out. During the past three quarters, real consumer spending has risen at a 4.7% annual rate, while real income is up only 3.4%, causing a big drop in the savings rate. The record surge in consumer installment debt since February might be reflecting consumers' increased tendency to borrow in order to make up the difference.

The problem: Last quarter's consumer retrenchment fueled a steep buildup of inventories. Stock levels of manufacturers, wholesalers, and retailers jumped 1.1% in May, the biggest increase in five and a half years. Some 43% of that surge occurred at retailers, with an additional 37% at wholesalers (chart, page 22). Retail inventories soared by 1.5% in May, the largest increase in qix and a half years.

Not only were June retail sales too tepid to pare down the problem, but July receipts also look weak. Sales at department and chain stores in the first two weeks of the month fell 0.9% from June, says Johnson Redbook Report.

Manufacturers continue to keep their stocks under tight control, but the inventory backup in retailing and eholesaling already appears to be curtailing some industrial activity. Industrial production at the nation's factories, mines, and utilities rose 0.5% in June, but that mainly reflected a 5.4% jump in utility output as air conditioners worked overtime in the unseasonably hot weather.

Output in manufacturing alone rose only 0.2% in June, about the same pace as in April and May, and for the quarter, production slowed considerably. Second-quarter output rose at an annual rate of 5.3%, down from a 7.8% pace in the first quarter.

A drop-off in auto and truck production accounted for much of that slowdown, but even excluding motor vehicles, June output still increased only 0.2%, about half the pace of April and May. And operating rates in manufacturing slipped to 82.8% in June, from 82.9% in May, the second dip in a row.

The production data also show that the capital-spending boom remained firmly in place last quarter, and that sector should add further to second-half economic growth. Output of business equipment, excluding autos and trucks, rose 0.6% in June. The second-quarter annual rate was 11.2%, about as strong as the 12.3% pace of the first quarter.

U.S. producers aren't the only ones adjusting to the consumer slowdown. It's a good bet that many of the goods now stacked in U.S. warehouses were made overseas. That should mitigate some of the negative side effects on the orders and output of U.S. manufacturers.

Another record level of imports caused a further deterioration in the U.S. trade deficit in May. The trade gap for all goods and services widened to $9.2 billion in May, from $8.5 billion in April. That's a sharp rise from March's $6.9 billion. Imports rose 1.2%, to $65.5 billion, while exports edged up just 0.2%, to $56.3 billion, after dropping 3.3% in April.

For goods alone, the trade gap mushroomed to $14.1 billion. That's up from April's $13.3 billion, and it was the biggest deficit since October, 1987, said the Commerce Dept. (chart).

The trade deficit with Japan shrank by about $1 billion in May, all of it coming from a big decline in imports. But for the first five months of 1994, imports from Japan grew by 9.3%, and the five-month trade deficit widened by $2.4 billion compared with 1993.

However, much of that deterioration reflects the surging yen, which increases the price of Japanese imports. Adjusted for prices, the erosion in real volume of trade with Japan looks far less worrisome.

The trade picture will probably improve in June. The influx of foreign World Cup fans boosted the U.S. travel surplus. Even so, foreign trade likely subtracted a bit from GDP growth in the second quarter.

Looking ahead, though, that drag may reverse itself. Just as American producers will have to cut back to avoid excess stockpiling, so, too, imports will probably slow to circumvent an inventory buildup of Mexican pottery, French wines, and Korean machine tools. Export growth, meanwhile, should look stronger by yearend, as recoveries in Europe buoy demand there for American-made goods.

In the past, a swing in the trade gap hasn't been as volatile for the economy as the pitch from an inventory correction. But with today's growing globalization, especially in manufacturing, foreign trade has taken on a greater importance in determining economic growth. And while slower inventory building may hamper output in the second half, better trade flows should help to power the expansion into 1995.

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