Growth Is Down, But Not Out

The key question about the U.S. economy right now is not "Is the economy slowing down?" It's "How much?" The way the third quarter is shaping up, growth may struggle to reach 2%, and it might end up being less than that.

Of course, the economy's fundamentals, such as consumer incomes and corporate profits, remain solid, suggesting that any growth swoon this quarter is not a prelude to a lasting malaise. But the third quarter, at least, is off to a poor start. July readings for real consumer spending and factory orders both fell, and the leading indicators were flat. August retail sales look uninspiring, and consumer confidence dipped.

The numbers say that overall demand in the third quarter has no bounce following its weak second-quarter showing. The Commerce Dept.'s revisions to last quarter's gross domestic product put growth in real final sales of all goods and services at a paltry annual rate of only 1.4%, a bit lower than the 1.5% pace first reported.

Commerce left its original reading for second-quarter real GDP largely unchanged. It revised growth to a 3.8% annual rate from 3.7%, despite the more substantial upshift generally expected. However, the latest data also left the huge inventory buildup intact--actually increasing the accumulation slightly, to a $56.3 billion rate, the largest quarterly growth in 61/2 years.

However, inventories cannot rise at that rate for very long. If stockpiles grow at a slower but more sustainable $30 billion pace this quarter, that would subtract about two percentage points from GDP growth. If so, the remainder of GDP, final sales, would have to rise 4% for the third quarter to manage a mere 2% advance.

The trouble is, demand is not growing anywhere near that fast. That's especially true in the consumer sector, which is two-thirds of final sales (chart). Real consumer spending in July fell 0.2% from June, putting quarterly growth so far at only a 0.5% annual rate. Just to reach a modest 2.5% pace for the quarter, monthly real outlays would have to rise a hefty 0.5% in both August and September.

That seems highly unlikely. August surveys of retailers show encouraging gains from a year ago, but not much strength compared with July. In particular, the Johnson Redbook Report's sampling of department and chain stores showed August sales up 8.7% from last year but down 1.1% from the previous month.

Higher interest rates have had their biggest impact on sales of homes, cars, and other durable goods. Real consumer purchases of durables fell 1.1% in July, mainly reflecting lower car sales. Sales of cars and light trucks have fallen for four consecutive months, suggesting that the weakness reflects more than just supply shortages of popular models.

Rising rates have clearly hit home buying. Although sales of new single-family homes rose 8.3% in July to an annual rate of 664,000, they had dropped 11.4% in June. July sales are about even with the second-quarter pace, which had fallen from the first-quarter level, and that was down from 1993's fourth-quarter peak. Existing-home sales slid 0.3% in July.

Although higher mortgage rates have cut some buyers out of the market, others are getting around higher borrowing costs by bargaining harder or settling for less. The increases in prices for both new and existing homes have slowed markedly. In July, in fact, the median price of a new home was below the selling price a year earlier.

Little wonder that builders' optimism is waning. The number of builders who expect "good" home sales in August held at the July rate of 32% after dropping steadily during the past several months from a high of 72% in November, 1993, says the National Association of Homebuilders.

Consumers' spirits are also flagging a bit under the uncertainty over the impact of the Federal Reserve's rate hikes, along with continued worries about job security. The Conference Board's index of consumer confidence dipped 2.3 points, to 89, in August, the second consecutive decline (chart). Households gave less optimistic assessments of both their present situations and their expectations six months down the road.

The combination of a slower pace of consumer spending and the big inventory buildup at retailers and wholesalers appears to be falling back on the manufacturing sector. Factory mrders for both durable and nondurable goods fell 2.3% in July, the largest drop in 21/2 years (chart). Even excluding the month's unusually large order declines in autos and aircraft, bookings were still weak.

Moreover, factory inventories jumped 0.9% in July, the largest increase in 31/2 years, with finished goods accounting for most of the increase. That's the first hint that production is running ahead of demand, portending a slowdown in factory production this fall.

Weaker ordering was one reason for the flat reading in the composite index of 11 leading indicators in July. The index, designed to project the economy's pace in the coming months, has gone nowhere since March--another sign that the economy is due for slower growth.

Of course, all this doesn't mean that the expansion is headed down the tubes. Two favorable trends are supporting both consumers and businesses: Solid job growth is buoying household incomes, and rising profit margins are boosting corporate earnings. These patterns will sustain a moderate if slower pace of economic growth heading into 1995.

In particular, corporate profits continue to exceed expectations. By Commerce's accounting, before-tax operating earnings, which adjust for changing inventory values and for the difference between tax- and replacement-cost accounting, jumped 7.7% in the second quarter, to an annual rate of $547.3 billion, a gain of 15.7% from a year ago.

Moreover, because of efforts to control costs and enhance productivity, profit margins continue to rise. Operating profits of nonfinancial companies as a percentage of real output rose to 12.8% last quarter, a record high (chart).

The strength in profits partly explains the stock market's summer rally. But more important, signs that the economy is slowing to a moderate, noninflationary pace mean that the Federal Reserve will not be hiking interest rates again any time soon. That removes a big cloud of uncertainty that had been hanging over investors.

The bottom line for consumers isn't skimpy, either. Personal income climbed a healthy 0.5% in July as wages and salaries scored another solid gain. After taking out taxes and inflation, real disposable earnings rose 0.2%.

The problem is that consumer spending has been growing faster than income. In the second quarter, real income grew a respectable 2.8% from a year ago, but real outlays rose 3.5%. The same thing happened in the previous year: income up 2.2%, spending up 3.4%.

That imbalance is a big reason why consumers are beginning to slow their spending and add to their savings. Of course, the underlying pace of incomes remains supportive of modest growth, which is why the economy is hardly in any danger of recession.

In fact, once the inventory overhang is pared down, demand will be the prime force in determining output. And because companies and consumers can depend on healthy earnings, economic growth could very well bounce back to 3% or so in the fourth quarter.

So when Commerce reports on third-quarter GDP in late October, don't panic. In fact, be happy knowing that the Fed, which meets shortly after the number comes out, is likely to have little justification for putting through another hike in interest rates.

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