This Slowdown Is Causing Some Whiplash

The past few weeks have seen scattered hints that the economy is cooling off. Now, the signs are clearer: This slowdown is for real.

When the Commerce Dept. takes a look back at first-quarter economic growth on Apr. 28, the numbers will have a lot to say about the rest of 1995 as well. That's because last quarter's real gross domestic product got most of its strength from surging inventories and only a smidgen of growth from demand. That combination is sure to curb growth in the second quarter and perhaps beyond.

Here's what to expect: a steep falloff in demand growth last quarter led by a sharply slower pace of consumer spending, a decline in housing construction, and a huge widening of the trade gap. That weakness swamped the continued strength in business investment in equipment and buildings.

On the plus side for GDP is a huge buildup in nonfarm inventories. Like the previous three quarters, inventories accumulated at one of the fastest paces in the postwar era. Unlike in 1994, though, the buildup last quarter appears to have been unintentional.

Add up the numbers, and first-quarter GDP growth looks to have been about 2.5%, half the fourth quarter's 5.1% rate. How much the reported number varies from that pace will depend largely on Commerce's assumptions for unknown March data, especially for inventories and foreign trade.

THE FEDERAL RESERVE should be especially pleased with the languid growth rate of demand, which should come in well below 2%. More important to policymakers, the new softness in consumer demand is not just temporary. Purchases of autos, home-related durable goods, and other items sensitive to interest rates are leading the pullback (chart). And new-home construction in March dropped to the lowest level in two years.

This pattern suggests that the Federal Reserve's rate hikes are responsible for the indifferent buying--not delayed tax refunds, the "O.J. effect" (wherein people would rather watch the trial than shop), or any other transitory factor. So the central bank is sure to hold rates steady at its next policy meeting, on May 23, and possibly even for the remainder of the year.

The size of the recent drop-off in retail sales shows a seismic shift in spending behavior. Retailers eked out a 0.2% gain in March receipts. But that followed a 1% drop in February, and March buying was no higher than it was five months ago. For the quarter, real retail sales fell at an estimated annual rate of 1.9%, the first quarterly decline in three years.

The jury is still out on April buying. A late Easter hurt sales in March, but it should help them this month. The weekly Johnson Redbook Report showed that department and chain-store sales for the first two weeks of April were 0.3% above their March average. Retailers have described sales in the first two weeks of the month as "on or below plan." Car sales in early April look weak compared with a year ago.

However, in the first quarter, at least, it's not just domestic demand that is downshifting. Export growth also slowed, partly due to the Mexican meltdown. Shipments to Mexico plunged in both January and February. March exports were likely down as well.

Overall exports rebounded in February, as aircraft shipments recovered from a January decline. Exports of goods and services rose 2.4%, but that followed January's 4.2% drop. So far in the quarter, shipments abroad are slightly below the fourth-quarter level.

The February export gain, plus a 2% decline in imports, narrowed the month's trade deficit by $2.9 billion, to $9 billion. The import drop is another sign that domestic demand is waning.

The smaller-than-expected gap should have bolstered the U.S. dollar, especially since the deficit with Japan narrowed for the fourth consecutive month. However, the buck continued to get bashed.

Even with the February improvement, though, foreign trade was a big drag on first-quarter GDP growth. Depending upon Commerce's assumptions for March, net exports appear to have subtracted about 1.5 percentage points from growth.

THE DROP-OFF in demand has come so swiftly that businesses were caught off guard. As a result, inventories piled up across all sectors in the first two months of the first quarter (chart). Stock levels of manufacturers, wholesalers, and retailers rose 0.9% in February, on the heels of an even steeper 1.3% jump in January. That was the largest two-month increase in inventories in more than a decade.

Most of last year's accumulation occurred in wholesale and retail trade in support of strong consumer spending. Now, however, stock levels are starting to look more burdensome, meaning that production and worktime will have to be cut.

Manufacturers have already started to respond. Factory inventories posted unusually large increases in January and February, a sign that retail-demand weakness is working its way back to the factory floor. The accumulation has been especially noticeable in factory inventories of finished goods and work-in-process.

NOT SURPRISINGLY, industrial production fell 0.3% in March. As a result of weather patterns, a large drop in utility output, following a big gain in February, exaggerated the March decline. However, manufacturing output alone fell 0.1% for the second consecutive month, something that hasn't happened in more than three years. Autos, trucks, and housing-related durable goods led the declines. Even business-equipment production slowed, although the high-tech sector of equipment remains in high gear.

Excessive inventories will slow production lines in the second quarter as well. Although factory output still grew at a solid 6% for the entire first quarter, down only a bit from 7.7% in the fourth, the recent declines will result in a sharply lower pace of second-quarter output. And without a pickup in demand, that output slowdown will extend into the third quarter.

Output of construction supplies slowed sharply last quarter, and it's little wonder. Housing starts plunged 7.9% in March, to an annual rate of 1.21 million (chart). That drop was the third in a row, and the single-family sector has led the decline. The three-month fall is the largest since the 1981-82 recession.

With industrial output slowing, capacity pressures and supply bottlenecks that usually push up prices are also easing. Operating rates fell in March for the second consecutive month, to 84.9%, the lowest rate since November. Already, inflation pressures from crude materials are easing: Industrial commodity prices are down from their recent peaks.

A handful of economists still believe that the emerging slowdown is only temporary. They argue that because of continued tightness in the markets for both labor and goods, building price pressures will cause the Fed to hike rates further. But the data now on the books--and yet to come--just don't support that notion.

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