Demand Makes A Sturdy Little Comeback

A month ago, the data seemed to raise the red flag for many economy-watchers. Flat retail sales, soaring inventories, and falling output lined up like so many ducks in a row, quacking recession. Now, though, thanks to fresh information and revisions, the data trumpet a far healthier economy, especially on the important demand side.

The latest economic news shows that shoppers were out spending last quarter, while businesses cut inventory gains in May, paving the way for at least a tiny uptick in factory output in June. Inflation, meanwhile, is hardly worth noticing.

If anything dims the outlook, it is the record trade deficit. A wider trade gap, along with slower inventory growth, is why growth in real gross domestic product struggled to stay positive in the second quarter. Final demand, though, was solid, and that upward trend is crucial to the economy's second-half performance.

THE HEALTHIER DATA made it easier for Federal Reserve Chairman Alan Greenspan to defend monetary policy to Congress. During his semiannual Humphrey-Hawkins testimony on July 19, Greenspan said the worst may be over. And while he would not completely rule out a recession, the chairman said: "Going forward, of the several credible outlooks, the most probable is for an upturn in the growth rate."

The Fed also released its economic forecast for 1995 and 1996. Real GDP should grow between 11/2% and 2% in 1995, and 21/4% to 23/4% in 1996. Consumer prices will rise between 31/8% and 33/8% this year, and only 27/8% to 31/4% in 1996. This lower inflation is significant to those hoping for further cuts in interest rates. Greenspan testified that "easing would be appropriate if underlying forces were clearly pointing toward reduced inflation pressures in the future." But his hint did not sway the financial markets. Sensing no immediate rate cut, the stock and bond markets tanked on July 19.

Greenspan also noted that the inventory correction may have been contained within the second quarter. That's partly because retailers were busier in the spring than first thought. The Commerce Dept. reported that retail sales jumped 0.7% in June, and it revised upward the April and May readings (chart). That means that instead of falling at a 2% annual rate in the second quarter as indicated a month ago, real retail sales grew at about a 2.3% pace.

Consumers were buying early in the third quarter as well. The Johnson Redbook Report said that sales at department and discount stores surged 1.1% in the first two weeks of July from June. Hot-weather items, such as air conditioners and pool supplies, were extremely popular, as residents in the Midwest and East tried to beat the record-setting heat and humidity.

Moreover, housing is settling down to a slower but steady pace. Starts fell just 0.1% in June, to an annual rate of 1.26 million, and May starts were revised higher. New single-family homebuilding jumped 3.9%, as buyers, lured by low mortgage rates in May, depleted what had been a high supply of unsold homes.

In fact, stronger consumer demand is helping to clear out all types of inventories. Earlier this year, manufacturers, wholesalers, and retailers saw excess goods pile up. But by May, companies had scaled back the growth in their stock levels.

Business inventories edged up 0.4% in May after gains averaging 1% in the previous four months. Apparel stores made particularly good progress. After their ratio of inventory to sales hit a 10-year high in April, the ratio came down sharply in May.

Less inventory growth reduced economic activity last quarter. If June stock levels also rose just 0.4%, inventory accumulation was about one-third less than in the first quarter--enough to subtract more than one percentage point from GDP growth.

The good news is that businesses wasted little time in adjusting their inventories after demand slowed early in the year. So, factory output will pick up sooner than it did in past inventory corrections.

THAT REBOUND may be starting. Industrial production eked out a 0.1% rise in June, following three consecutive declines. So for the third quarter, output dropped at a 3.3% annual rate. Industrial operating rates slipped to 83.5% in June, from 83.7% in May.

Factory output alone rose 0.1% in June after two monthly declines. Manufacturing production fell by 3.9% last quarter, led by consumer goods (chart). Hours worked in the factory sector, however, fell by twice the output drop. That suggests another jump in factory productivity--one reason why profits rose last quarter, even as the economy slowed.

With the inventory problem abating and demand firming, industrial output should pick up in coming months. In July, the heat wave alone greatly pushed up utility demand for the month.

BUT STRONGER DEMAND also means that foreign trade will continue to be a serious drag. The trade deficit for goods and services defied expectations in May, remaining at $11.4 billion (chart). Exports rose by a respectable 1.3% in May, to $64.8 billion. That reflects strong demand overseas for capital goods, which set a record in May, despite a plunge in aircraft exports.

But imports also grew to another record in May, advancing 1.1%, to $76.2 billion. Even as the Fed has tried to choke off domestic demand over the past 11/2 years, imports have been surging at a 13% yearly pace. Without some slowdown in this inflow, the U.S. cannot hope to reverse the deterioration in trade.

The June deficit should narrow. Japan has already reported a drop in its surplus with the U.S. (see below). But even if the June gap shrank to $10 billion, foreign trade may have robbed almost one percentage point from the growth in second-quarter GDP.

The import wave is also importing some inflation, a fact noted in Greenspan's testimony. Inflation in consumer-goods imports still trails the rise in consumer prices overall. But the weak dollar and high global demand for business equipment mean that import prices of capital goods have picked up steam.

Such prices have risen 3% from a year ago, much faster than the 0.7% increase of the previous 12 months and the 1.7% pace of U.S. producer prices of capital goods. The gap opens the door for U.S. producers of capital goods to mark up their own prices.

In general, though, inflation remains in the shadows during this expansion. Consumer prices rose only 0.1% in June. Excluding food and energy, prices were up 0.2%. And producer prices of finished goods actually fell 0.1% in June, while the core rate rose by 0.2%.

In the first half of 1995, total consumer inflation is running at a mild 3.2% annual pace, with the core rate up 3.6%. Because the economy is unlikely to grow much more than 2.5% in the next few quarters, few price pressures should materialize.

When combined, the modest inflation outlook and the signs of renewed demand offer the economy the best of both worlds. Don't look for a repeat of the spectacular runup of 1994, but the expansion in 1995 continues to avoid the dangerous shoals of recession.

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