Don't Be Fooled. The Economy Is Still Too Hot For The Fed

Every good mystery has a few red herrings scattered among the relevant evidence. In the search to pinpoint the arrival of a slower economy, the latest data throw out conflicting clues. In December, industrial output was exceedingly strong, but retail sales were a big disappointment. Which is the real McCoy and which is the MacGuffin?

Deciding which indicators give a true picture of the economy is crucial for the Federal Reserve Board right now. After hiking interest rates six times in 1994, Fed policymakers will sit down again on Jan. 31-Feb. 1 to decide whether the economy needs yet another dose of restraint.

Make no mistake: Slowing the economy is the raison d'tre for Fed chairman Alan Greenspan & Co. They see that as the only way to hold back inflationary forces. But with monetary policy already in a restrictive mode, misreading the tea leaves now could spell trouble later on: Overtighten, and the economy could stagnate.

That's especially true since foreign demand may well be a tad weaker this year than first thought. That's because the devaluation of the Mexican peso is reverberating through other economies. As sell-offs in financial markets around the world show, investors are shunning high-debt, fiscally unsound countries. One result is tighter credit conditions globally that will slow growth worldwide and mute some of the expected strength in U.S. exports. Exports to Latin America accounted for about a third of U.S. export growth in 1994.

IT'S DOMESTIC DEMAND, though, that will bend this economy to a noninflationary pace. And the December report on retail sales seemed to point to a slowdown. Not only was the 0.1% drop unexpected--the median forecast among economists was a 0.7% gain--but the Commerce Dept. also revised the November increase down sharply, from a 1.2% jump to 0.2%. The bond market rallied sharply on the retail data, and the stock markets also boomed, as the odds of another Fed rate hike seemed to lessen.

But in light of December's surprisingly robust industrial activity, the retail sales report looks like a red herring. Retail sales are one of the government's most volatile indicators, and as the November revision shows, the December drop may not hold up as more retailers report in. Moreover, a look below the surface suggests that buying for the entire quarter was pretty strong--especially for durable goods, the very sector where the Fed's rate hikes should be having an impact (chart).

Yes, demand for durable goods weakened in December--but after four months of strong buying. Building materials, furniture, and electronics got snapped up. Even after adjusting for price changes, quarterly sales at durable-goods stores shot up at an annual rate of 21%.

Retailers in the nondurable categories--from grocery stores to gas stations to restaurants--had a harder time in the fourth quarter. Department stores, in particular, had to pump up their sales volume by cutting prices during December in order to compete with discounters--increasingly, the merchant of choice in the 1990s. That means real purchases of nondurable goods rose at a modest 2.5% in the fourth quarter.

For retailers, sales promotions meant yearend profits were quite a letdown, the chief reason retailers sound so humbug about holiday sales. But for consumers, November and December sales rose 6.8% from a year ago. That's not bad, considering that 1993 receipts posted a 7% gain, a result retailers seemed quite pleased with at the time.

THE RESILIENCE of consumers is one reason the Fed is apt to ratchet up rates at the end of January. The Fed's latest survey of activity in each of its 12 regions, prepared for its upcoming meeting, reported that the "economic expansion remained vibrant across much of the nation."

The report also said that "the underlying momentum in consumer spending growth remained quite strong" in December and early January. Indeed, household buying last quarter appears to have boosted real gross domestic product at an annual rate of at least 4%--the third quarter in a row in which growth was 4% or better. That's a killer pace in the eyes of the Fed.

The strength in the factory sector, especially the jump in operating rates (chart), is an even tougher argument for a rate hike. The 1% surge in industrial output in December--the largest in more than two years--shows an economy headed into 1995 with plenty of momentum.

Factories alone lifted output by 1% in both November and December. For the fourth quarter, total industrial output grew at a 5.4% annual rate, and factory production rose 7.3%--the same pace as in the first half of 1994 before any rate hikes had a chance to bite.

Like retail sales, durable goods are a key to industry's strength. Output of consumer durables was up 6.4% in the fourth quarter, and business equipment surged 11%, with a 27.2% gain in computers and office machinery.

FOR THE FED, the sharp rise in utilization rates has to be particularly worrisome. All industry used 85.4% of capacity in December. That's up from 84.7% in November and is the highest operating rate in 15 years. In primary processing, the rate rose from 89.3% in November to 90% in December, the highest in 21 years. Traditionally, an operating rate of more than 85% is one of inflation's smoking guns.

But while rising plant use suggests at least a slight pickup in inflation this year, the Fed must also factor into its policy talks the concerns that the operating rate is no longer a dependable gauge of price pressures. Many economists argue that slack capacity abroad acts as a safety valve if operating pressures become too high in the U.S. Also, businesses are using computers and other technology in an effort to boost efficiency, which increases their output capabilities.

One factor that promises to take some of the starch out of the factory sector as the year wears on is inventories. Business inventories remained quite lean in relation to sales in November, but that reflected skimpy inventories at the manufacturing level. Inventories in manufacturing, wholesaling, and retailing rose 0.7% in November against a 1% increase in business sales.

For retailers alone, however, inventories have been growing faster than sales for three of the past four months. The imbalance is especially acute outside of car dealers. The ratio of nonauto inventories to sales in November rose to the highest level in 81/2 years (chart). And after December's soft sales, retailers may have started 1995 with more goods than they wanted, making vendors skittish about reordering in 1995. Although foreign producers will take some of the hit, domestic manufacturers will feel some drag as well.

Right now, though, the overwhelming body of evidence points to a stubbornly strong economy headed into 1995 with considerably more momentum than the Fed wants. To be sure, Fed tightening will slow the economy this year, but not even the central bank can be sure when that will happen. That's why the first rate hike of 1995 may not be the last.

Before it's here, it's on the Bloomberg Terminal.