The Dips In The Road Won't Last Forever

The economy's goods-producing sector has always been the Federal Reserve's whipping boy when it comes to disciplining an unruly economy--and thereby containing inflation. The punishment eventually takes a human toll, especially on workers in manufacturing and construction. This time the pain is coming especially fast.

The 101,000 drop in the nation's payrolls in May, following a slight dip in April, shocked economists, financial markets, and probably even the Fed. It was a recession-size decline, larger than any since the 1990-91 downturn. True to form, workers at factories and building sites took the biggest blow.

Other downbeat reports: Consumers, faced with higher tax bills, cut back on spending in April. The nation's purchasing managers said the industrial sector was in recession in May. And a triple dip in the index of leading indicators is another red flag of trouble ahead.

Fueled by new fears of recession, the bond market exploded on June 2 in the largest intraday rally in a decade, before giving back some gains. Yields still closed at a 15-month low. And the latest data, especially the May job losses, place increasing pressure on the Fed to ease policy.

The credit markets are inviting a rate cut. The rate on one-year Treasury bills is now more than a quarter point below the Fed's 6% overnight federal funds rate. However, comments by top Fed officials on June 7 left the markets less certain that a rate cut was imminent. Most notably, Fed Chairman Alan Greenspan said that, as might be expected, the probability of recession has "edged up," but he also said that the developing slowdown was a desired result of Fed policy.

ONE THING IS CLEAR: The current slowdown is far from the soft landing that most observers had in mind when the Fed set out to slow growth from an inflationary pace of 4% in 1994 down to an inflation-neutral growth rate of about 2.5%. Based on the latest numbers, second-quarter growth in real gross domestic product will struggle to clear 1%.

The good news, however, is that the weakness still appears to be temporary and unlikely to feed on itself in a way that would send the economy spiraling downward into a painful recession.

So far, the softness is concentrated on the output side of the economy, mainly in the goods-producing sector. The production weakness suggests that what's going on is primarily an attempt by businesses to wrestle their excessive inventories into better alignment with slower growth in demand. Once stock levels are adjusted, manufacturing output will pick up again.

Of course, this assumes that consumer demand doesn't suddenly sink into oblivion. On that score, the news is encouraging. Although real consumer spending on goods and services fell 0.1% in April, retailers reported healthy May sales. Also in May, Detroit announced that sales of U.S.-made cars and light trucks rose to an annual rate of 14.6 million, up from a tepid 13.9 million pace in April.

AT FIRST BLUSH, April's huge 1.1% drop in households' real aftertax income would appear to blight chances for healthier consumer spending. However, special factors were at work. The second installment of the 1993 tax hike on the wealthiest individuals subtracted a huge $50 billion from incomes, at an annual rate.

May incomes will return to normal. Also, by the end of April, the Internal Revenue Service had caught up with its mailing of refund checks, which had been delayed. That may have played a small part in recent consumer weakness. But at the end of May, refunds totaled a record $8.8 billion, twice the year-ago pace.

Those checks may be helping June spending. The Johnson Redbook survey of retailers shows strong sales in early June, compared to May. And consumer balance sheets look healthy. Mortgage delinquencies in the first quarter dropped to a 22-year low, and a new wave of refinancing will lift cash flow.

Besides, the recent slowdown in consumer spending has not been broad. The weakness has been solely in durable goods. In the first four months of the year, the pace of the remaining 85% of outlays has picked up.

And almost all of the decline in durable goods sales was in motor vehicles. That's why the inventory correction, and the need to throttle back output, is heavily concentrated in the auto and related industries.

Detroit's gyrations may also be exerting a disproportionate impact on the purchasing managers' index, which tends to be highly correlated with fluctuations in the output of autos and trucks. The purchasers' gauge of industrial activity dropped in May to 46.1%, from 52% in April. That's below the 50% line dividing recession from expansion in manufacturing.

Almost all of the components fell, including orders, production, employment, and inventories. In particular, the inventory index dropped to a level suggesting factory inventories have stopped growing and may well begin to decline. This hints that, as June began, inventory correction was underway. Official inventory data from the Commerce Dept. run only through April right now, and manufacturing and wholesale inventories were still rising in April.

BUT WHILE THE SLOWDOWN looks to be only temporary, it also is turning out to be sharp. The May employment report was a real head turner. The numbers were weak from top to bottom. Manufacturing lost 56,000 jobs on top of the 25,000 shed in April, and construction laid off 57,000 workers after April's 19,000 decline. Service companies managed to increase payrolls by 36,000, a tiny amount by recent standards.

In addition, the May workweek fell by a steep 18 minutes, to 34.3 hours. That drop, plus the relentless rise in jobless claims, portends further weakness for payrolls in June.

In the factory sector, the workweek held at April's reading of 41.5 hours, but because of fewer jobs and less overtime, the data imply that factory production in May declined for the fourth month in a row, likely led by another big drop in car and truck output.

Another eye-popping number was April's 0.6% drop in the government's index of leading indicators, those that point to the economy's future. The April decline was the third in a row, a traditional warning that recession is just around the corner. And based on May data so far, the index likely fell again in May.

Bear in mind that the leading index has a spotty record at calling recessions. The problem: Five of the 11 indicators that comprise the index are directly linked to manufacturing, which has shrunk to only about 20% of the economy's GDP and now accounts for less than 16% of total employment. Consequently, the index in recent years has acted more like a coincident indicator, telling us more about where we are and less about where we're headed.

Sadly, May's job losses do a much better job of describing where we are right now. But unless consumers suddenly abandon the malls--which seems unlikely--the pain will be short, and the gain will be an extended life for the expansion.

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