The Economy Is Healthier But Don't Expect Handsprings

When the Federal Reserve sits down on Sept. 26 to decide where interest rates should be, what will it do? The current betting among economists is that the Fed will do nothing, leaving the federal funds rate on overnight loans between banks unchanged at 5 3/4%.

But any decision won't be easy. What the Fed must decide is twofold: How solidly is the economy rebounding, and how restrictive should policy be? So far, the tea leaves strongly suggest that the pickup is only modest and that policy is overly restrictive, given the excellent inflation outlook.

If so, a rate cut at the upcoming meeting cannot be ruled out. And even if the Fed stands pat, that doesn't mean that a future rate reduction is out of the picture.

With the latest data, which show the economy recovering from its first-half malaise, support that view. In August, strong car buying led a gain in retail sales. Housing starts posted their fifth rise in a row. Industrial production surged. And in July, business inventories grew at their slowest pace of the year.

The mix of summer numbers say that the ongoing rise in demand plus past cuts in production have largely eliminated the inventory overhang that had plagued businesses earlier this year. A more manageable level of inventories is clearing the way for further gains in output and jobs, especially in the factory sector.

Even so, the economy isn't about to do handsprings. Consumers, while still hanging in there, will not repeat 1994's yearend buying spree.

One reason is that they are carrying a lot of new debt now that is becoming harder to pay off. In the second quarter, 1.95% of consumer installment loans were more than 30 days overdue. Delinquencies have risen for three consecutive quarters. At the same time, job growth, while a bit better in recent months, is slower than it was last year, meaning that incomes will rise with less vigor.

THAT IS WHY SPENDING remains uneven. Retail sales rose 0.6% from July, but excluding cars, store receipts did not grow in either July or August. And the government revised overall July sales down.

In terms of gross domestic product, however, consumer spending will contribute to third-quarter growth. Because outlays began the quarter on such a high level, reflecting strong increases at the close of the second quarter, real consumer spending appears to be rising at an annual rate of 2.5% to 3% this quarter. But that's neither brawny nor broad.

Moreover, households seem a little more cautious. The University of Michigan's preliminary index of consumer sentiment dropped more than seven points in early August, to 88.9, the lowest reading since December, 1993. Early readings on September buying, based on the retailer survey by the Johnson Redbook Service, suggest only moderate retail activity.

The housing rebound needs to be kept in perspective as well. Starts edged higher in August, to an annual rate of 1.40 million from 1.39 million in July. As lower interest rates cleared out some of the inventory of unsold homes, starts have risen 13% since hitting their recent bottom in March, but homebuilding remains below its year-ago level.

Regionally, housing starts since March are up in the Midwest and the West. The South, which accounts for 46% of all starts, contributed nearly 60% of this year's rebound. Starts in the Northeast are below their March level.

In addition, the increase in new mortgage applications to buy a home topped out in mid-July, and have been falling since then. All this means that housing will be an asset for the economy going forward, but the gain will be only a small plus.

Foreign trade, however, remains a minus. The July trade deficit widened further to $11.5 billion, from $11.3 billion in June. Imports fell 1.7%, but exports dropped 2.3%. The trade gap began the third quarter wider than its second-quarter reading.

ONE AREA THE FED will pay special attention to is manufacturing. Some of Chairman Alan Greenspan's favorite indicators relate to the factory sector, because they often foreshadow turns in the broader economy.

In that regard, the 1.1% jump in industrial production in August is key. Although special factors, including a 4.9% weather-related surge in utility output and a 6.4% bounce in auto and truck production, exaggerated the overall advance, the gain was sturdy and broadly based.

Output in manufacturing alone rose 1%. Even without the automobile sector, factory production increased an impressive 0.7%, led by gains in business equipment and consumer durables businesses. In the six months prior to August, factory output had either fallen or not grown at all.

Still, August's strong output gain does not look sustainable. First of all, current modest demand growth will not support any more increases that large. Second, now that manufacturers have worked to get their inventories lower, they will be cautious about adding goods in coming months. Inventories held by factories, wholesalers, and retailers rose only 0.3% in July. They had risen an average of 0.6% per month in the second quarter and 1% per month in the first quarter.

The inventory correction, while winding down, is not finished, however. In particular, car output seems to be running somewhat ahead of demand, and retailers may still be in the process of clearing out stockrooms. Their inventories fell 0.7% in July. If the sales jump kept August inventories flat, the ratio of retail sales to inventories likely slipped to 1.51, consistent with the average of this expansion (chart).

However, with consumer demand for goods expected to grow slower than its 3.5% annual pace so far in this upturn, stores may want to start trimming their inventories just a bit more. Slower inventory growth in the third quarter promises to be a substantial drag on GDP growth.

IN THE FACE OF what is most likely to be only moderate economic growth heading into 1996, the degree of restrictiveness of Fed policy becomes important. By the Fed's own measure of real interest rates, policy appears to be fairly tight right now.

With the federal funds rate at 5 3/4%, and with inflation expected to remain at less than 3%, the real funds rate is now a shade over 2 3/4%. That level is more than one percentage point above the real funds rate's long-term average of 1 3/4%, which is considered a neutral stance for policy. Above that level, policy is often regarded as restrictive; below that rate, it is accommodative. The Fed has to decide if that level of restrictiveness is warranted.

Moreover, monetary policy cannot ignore fiscal policy. The Fed will probably want to wait and see how much near-term deficit reduction is contained in the 1996 federal budget before sanctioning another drop in rates. But if the budget cuts look credible--and if the economy is no peppier than it is now--look for lower rates by yearend.