The Economic Slowdown: The Worst May Already Be Over

"Will you, or won't you?" That was the key question put to Alan Greenspan by Martin S. Davis at the June 20 meeting of the Economic Club of New York regarding the Federal Reserve Chairman's inclination to cut interest rates. His answer: Yes and no.

Greenspan's expected avoidance of the question may well mask many of the Fed chief's own uncertainties about the economic outlook, or so it appeared from his remarks that evening. While Greenspan suggested that it's never a good idea to pack away your recession fears when an economy looks as weak as this one, he still seems unconvinced that the economy is sufficiently at risk to ease policy.

Indeed, a glimmer of a silver lining is beginning to form around some of the second quarter's darkest data. Notwithstanding the puny-looking April and May numbers on consumer spending, housing, and the labor markets, several early-bird readings for June suggest that much of the economy's weakness will prove to be temporary. For example, unemployment claims, retail sales, and mortgage activity all show improvement from May.

One dark cloud over the second quarter could be foreign trade. The April trade deficit for goods and services widened unexpectedly, to $11.4 billion from $9.8 billion in March (chart). Exports fell 1.3%, partly reflecting another sharp drop in shipments to Mexico, while imports jumped 1%, hitting yet another record.

The gap will have to narrow considerably in May and June for foreign trade to avoid being a big drag on second-quarter growth. For the rest of the year, however, imports are bound to slow, given the weaker U.S. economy, and exports will pick up as the Mexican economy stabilizes.

BUT WHILE IT'S EASY to focus on the second quarter's weakness, the crucial questions for the outlook, and especially for Federal Reserve policy, are the slowdown's three D's: its depth, duration, and dispersion.

The early June readings strongly suggest that the economy has slowed but not stopped. The weakness will last only as long as it takes for businesses to adjust their top-heavy inventories, a process that appears to be moving forward. And while the slowdown is fairly broad, deep cuts by the auto industry are making it look worse than it really is.

Greenspan told the Economic Club that the pattern of the inventory correction would be "crucial to the outlook," that is, whether inventories are brought into line quickly or if the process is more drawn out with a more severe impact on the economy.

But while Greenspan sees inventories dominating the near-term outlook, he said the key underpinning for sustained growth was demand. On that score, he admitted, "uncertainties abound," since the inventory adjustment itself can feed back adversely on demand.

Greenspan strongly suggested that policy was at a crossroads. He said now is "a time for intensifying our normal surveillance and analysis of ongoing developments, to gauge whether policy still is appropriately positioned to foster sustained economic expansion."

He appeared to be preparing the markets for an eventual easing of policy. But because of uncertainty over how the slowdown generally, and the inventory correction specifically, will play out, the Fed seems unlikely to move at its July 5-6 meeting. It should be a lively affair, given recent divergent policy statements by various Fed officials. The New York audience erupted in laughter when Greenspan promised that the meeting would be "most engaging."

THE FED'S LATEST REPORT on the economy noted that economic activity "remains at a high level" across much of the U.S., but there are signs of "some softening" in many of the Fed's 12 districts, especially in interest-sensitive sectors such as housing and autos.

Detroit's impact on output was clear from May's report on industrial production, which fell 0.2%, the third consecutive decline (chart). Output in manufacturing alone dipped 0.3%, the fourth drop in a row. Since February, when auto production peaked, factory output has fallen at an annual rate of 3.8%. But excluding motor vehicles and parts--only about 6% of factory output--production has declined at only a 1.9% pace.

Production cuts and better May car sales are bringing auto inventories into better shape. That means overall business inventories in May and June will be growing more slowly than April's large 0.8% increase.

At least modest consumer-spending gains are critical to the quick completion of the inventory adjustment. And on that score, the signs are encouraging. Despite weaker labor markets, consumer attitudes were more upbeat in early June, according to the University of Michigan's index of consumer sentiment. The index rose to 92.3 from 89.8 in May, with a sizable increase in expectations for the future.

CONSUMERS MIGHT WELL remain confident because weakness in the job market is not so widespread as to be worrisome. Indeed, initial jobless claims through mid-June have declined for three weeks in a row. If that pattern continues, it means that labor-market weakness has bottomed out.

Retail surveys are generally upbeat about June sales. The Johnson Redbook tally shows seasonally adjusted sales through the first three weeks of the month up 1.5% from the May level. That pace is consistent with a fairly healthy consumer sector.

Housing may also be in for better times later in the second half. Housing starts dipped 1.3% in May, to an annual rate of 1.24 million. The drop nullified April's small increase, knocking starts back down to their March level, and new construction of single-family homes fell to the lowest level in more than two years.

However, lower mortgage rates are lifting demand. The average rate on a 30-year fixed loan had fallen to 7.75% in mid-June from a recent peak of 9.32% back in January. That dropped the average monthly payment on a $100,000 mortgage from $828 to $699.

So far in June, mortgage applications to buy a home have jumped more than 6% from May, and May's paperwork was up more than 10% from April. Applications in mid-June were the most in almost a year (chart). That rise will show up in sales data later in the summer and in early autumn.

For now, builders are working through a heavy backlog of unsold homes, the largest supply in about five years. The good news is that construction companies are seeing signs of better times. An increasing number of them in June saw improving current demand and better traffic through model homes, and more expected demand to get better during the next six months, according to the National Association of Home Builders.

All of this hardly adds up to an ebullient economy. In particular, some of the data in coming weeks is bound to show continued weakness. That's why Greenspan believes that the probability of a recession has risen. But based on reports so far, that probability seems unlikely to become reality.

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