Don't Let The Signs Of A Slowdown Frighten You

Consider this equation: 2.8+3.1=6. The new math run amok? Or addition using an old Pentium chip? No, the quirky arithmetic seems to sum up correctly the economic outlook right now.

The real gross domestic product grew at an annual rate of 2.8% in the first quarter, down from the 5.1% gallop of the fourth. The slowdown in final demand was more dramatic. Final sales inched up 1.8%, less than a third of the sales gain at the end of 1994. Faster inventory accumulation accounted for the other one percentage point of growth last quarter.

At the same time, inflation remained well behaved. The GDP fixed-weight price deflator rose at a 3.1% annual pace in the first quarter, tame enough to ease any inflation anxiety at the Federal Reserve.

That's the place where 2.8 plus 3.1 may well equal 6. At the Fed, 6% is the current Federal funds rate, the interbank lending rate used to control monetary policy. With demand slackening and inflation hardly noticeable, the need for further rate hikes diminishes. The chance that the funds rate will stay at 6% for the rest of the year increased greatly after the GDP data were released on Apr. 28.

Other signs point to an ongoing slowdown. Consumers are losing interest in homes and cars. Purchasing managers say industrial activity is down a notch, and the government's index of leading indicators fell 0.5% in March, the second drop in a row.

Taken together, the data suggest that growth this quarter could end up below 1%. But don't despair just yet. Capital spending and exports will pump economic growth back above 2% in the second half.

THE APPARENT COLLAPSE in the economy this quarter comes from a correction in inventories. The $63 billion gain in stockpiles last quarter was the largest in 101/2 years. In fact, in three of the last four quarters, inventory increases have outpaced final sales (chart).

Last quarter, businesses underestimated the pullback from consumers whose real spending increased at just a 1.4% annual rate compared with 5.1% in the fourth. In addition, the Mexico crisis likely meant companies did not ship many goods south.

With the latest data confirming that softer demand is here to stay, businesses no longer need to stock goods so rapidly. If inventories now are rising at half their pace of the first quarter, the slowdown would subtract more than two percentage points from GDP growth. So if demand rises somewhere between 2% and 3%, real GDP will grow less than 1% this quarter.

THE INDUSTRIAL SECTOR is already adjusting to a softer economy. The National Association of Purchasing Management's index stood at 52% in April. That's only a bit better than March's figure, 51.4%, and both readings are perilously close to the 50% mark that indicates industry is just treading water.

The purchasers reported that output and orders improved. But they also said that delivery times were shorter in April than in recent months and that the index of prices paid fell for the fourth month (chart).

That means production bottlenecks and shortages of goods--usual precursors to higher consumer inflation--are not materializing. More capacity will be freed up this spring as manufacturers fill orders out of inventories instead of from new production. Already, carmakers have announced cuts in their second-quarter production schedules because of weak sales.

In fact, a fall in motor-vehicle sales led the 4.7% drop in consumer outlays for durable goods last quarter. And the decline in car sales continued into April. Total retail sales will look better because of a late Easter and the delayed delivery of tax refunds held by the government as it checked for fraud. Will spending head south later on? That's unlikely because household incomes are still growing. Real disposable income advanced at an annual 4.4% rate last quarter, and in March it rose 0.4%.

Higher interest rates, however, have increased the monthly payments on old debts such as adjustable-rate mortgages and credit-card bills. Remember that 1994's holiday shopping spree was financed largely on credit. Those bigger bills are why spending will not rise at the same pace as incomes in 1995. But while slower hiring will limit pay gains, it will not be enough to cause a sharp falloff in consumer spending.

Housing, however, will suffer this year. New single-family home sales bounced back in March--thanks to a dip in mortgage rates--rising 3%, to an annual rate of 577,000. But that followed a 12.5% plunge in February, and sales have been falling since last summer (chart).

Residential construction dropped 6.6% last quarter, but even so, builders ended the period with an overhang of unsold properties. The number of new houses for sale rose to 349,000 in March, a five-year high. Even if builders do not hammer another nail, their inventories of unsold houses could support 7.3 months of home buying at March's selling rate.

INSTEAD OF consumers propping up growth this year, the economy will have to rely on capital spending and exports. That's where the outlooks are most favorable.

Business investment on new plants and equipment surged at a 19.3% annual rate in the first quarter. Spending on equipment alone shot up by 20.8%. Companies are able to invest in machinery that will improve productivity and lower costs because profits are still growing at a robust clip.

One good twist in 1995: Businesses will spend more on buildings, reversing the prolonged downtrend in commercial real estate. Nonresidential construction grew 14.1% last quarter, and F.W. Dodge Div./McGraw-Hill Cos. reports that contracts for new commercial buildings rose 7% in March. Total contracts fell 3% because of weaker housing.

U.S. companies will keep adding to capacity even as domestic growth slows because their goods will be in demand overseas. Exports were flat last quarter, due in large part to the fall in shipments to Mexico. But demand elsewhere will take up the slack. Foreign shipments will do better in the second half, as growth in Europe and Latin America improves.

Imports, meanwhile, rose 5.9%, causing a deterioration in net exports. The first-quarter deficit widened to $119.7 billion, from $107.1 billion in the fourth quarter, subtracting one percentage point from GDP growth.

Many of those imports ended up in warehouses, though. That means that the inventory correction now going on will hurt foreign producers almost as much as U.S. manufacturers. Growth in imports could slow sharply in coming months, improving the trade gap. A lower deficit will add to GDP growth--another reason not to worry if the second quarter looks awful.

Indeed, the economy rarely slows or expands in a straight path. As long as growth does not consistently deviate from the 2.5% mark considered to be the Fed's target for noninflationary growth, the crazy curves in the economy won't alarm policymakers. And they shouldn't scare you, either.

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