One Quarter Of Zippy Growth Won't Spoil The Soft Landing

Is the economy taking off again? Just when the soft landing seemed like a done deal, along comes word that third-quarter growth jumped to a 4.2% annual rate, a sharp speedup from the second quarter's 1.3% showing. Is it time to revive those worries about overheating?

If you are concerned that rapid growth will continue and set off a round of rising inflation, tightening monetary policy, and higher bond yields, you can relax. Like any 4 1/2-year-old, this expansion will experience a growth spurt now and then, and the third quarter's was helped by a couple of special factors. Moreover, the fundamentals necessary for a speeding economy are simply not in place at the moment.

As a result, fourth-quarter growth is most likely to settle back to the noninflationary trend of about 2.5%. In fact, based on the Commerce Dept.'s new chain-weighted measure of gross domestic product, which will become the gospel on economic growth in a month or two, real GDP grew only 3% last quarter.

Why the moderate outlook? Consumer spending will be limited by job growth that is half of last year's pace and by high debt levels that are beginning to burden some households. Low-tech capital spending, accounting for two-thirds of every dollar spent on new equipment, is slowing down. Also, the lift to housing from this year's drop in mortgage rates is about played out. And having been caught with excess inventories in the spring, businesses will be wary about building them up again too rapidly.

IF ANYTHING, the microburst of growth in the summer may be stealing some pep from this quarter. The National Association of Purchasing Management's business index took an unexpected spill in October. The NAPM index fell to 46.8%, from 48.3% in September (chart). The readings on production, orders, inventories, and employment all weakened last month.

The NAPM survey shows that while the factory sector contracted in October, the overall economy was still growing. An autumn slowdown was also the view of the Federal Reserve's survey of economic activity within its 12 districts, prepared in advance of the Fed's Nov. 15 policy meeting.

The so-called Beige Book said that "moderate growth in economic activity continued in early fall, although perhaps at a slower pace." In particular, the report suggested "a pause in retail sales in some districts." At the same time, the survey showed that wage hikes remained "moderate," and the upward pressure on materials prices was abating.

Both pieces of news suggest any inflation worries are misplaced. In the third quarter, the inflation rate, as measured by the fixed-weight price index, fell to 2.1%, the lowest in two years. The implicit price deflator posted the smallest increase in 32 years.

Low inflation was a key highlight in the third-quarter GDP report--especially since it came at a time when final sales were so strong (chart). Rising demand by consumers, businesses, and government accounted for all of the quarter's advance. Inventory growth was as big in the third quarter as in the second.

Two factors exaggerated the second quarter's weakness and the third quarter's strength in real GDP. One was a 10.2% annual rate of gain in federal nondefense purchases last quarter, reversing the second quarter's 8.6% drop. The government sector probably will subtract from fourth-quarter growth, and amid budget cutting, it will not be much of a contributor next year. Swings in the auto industry also have skewed this year's economic performance.

The economy's biggest sector--consumer spending--rose at an annual rate of 2.9% last quarter, following a 3.4% increase in the second quarter. Households are unlikely to maintain that pace, however. During the past two quarters, real aftertax income has risen at only a 1.6% annual rate. In fact, based on the Johnson Redbook Report's survey of retailers, October sales at department and chain stores fell 1.8% from September. That's another sign that October was rocky for the economy.

STILL, CONSUMERS are not ready to pull in their horns entirely. Their optimism in this economy remains too high for all-out shopper retrenchment. The Conference Board's index of consumer confidence stood at 97 in October, little changed from 97.3 in September.

In addition to a more sedate consumer sector, the GDP report also showed a slowdown in capital spending for equipment, mainly low-tech industrial items. Low-tech spending rose at an annual rate of 3% last quarter, compared with 6.5% in the first half. High-tech outlays cooled down to a 16.2% growth rate, from the first half's 31% gallop.

Housing construction rose at a 10.9% annual rate last quarter, the best gain in 1 1/2 years. But here too, the pace appears unsustainable. With mortgage rates bottoming out, sales of new single-family homes are peaking. After hitting a high for the year in July, sales fell 11.1% in August, and they rebounded only 3.3%, to an annual rate of 727,000, in September.

Overall construction spending did end the third quarter at a lively pace. Building outlays jumped 1.2% in September, the fourth straight increase. Residential and public construction projects led the advance.

LUMPED TOGETHER, businesses, consumers, and government should keep their spending rising steadily, if less robustly than in the third quarter. At the same time, though, rising inflation will remain out of the picture. That's a curious notion when you consider that real wages are finally crawling into positive territory.

Low inflation, however, is the result of improving productivity, which is nearly outpacing the growth in payroll costs and thus keeping unit-labor costs from rising much. For the third quarter, economists expect another good gain in output per hour worked--although not near the 4.8% surge of the second quarter--while labor costs continued to slow.

The Labor Dept.'s report on employment costs shows that wages and benefits for civilian workers rose just 0.6% last quarter. Over the past year, they're up 2.7%--the lowest pace since Labor began keeping records in 1982. Although employment costs are not exactly equal to the compensation data used to calculate unit labor costs, both measures have been trending lower.

A sharp drop in the growth of benefits is leading the downward drift in labor costs (chart). Smaller increases in the cost of employee health care is the main reason. In the third quarter, the cost of health-care benefits was actually lower than a year earlier. Yearly wage growth bottomed out three years ago and has been creeping higher since then. Third-quarter pay was up 2.8% from a year ago.

The small increase in wage growth has been one key to keeping the expansion going while moderating inflation. And despite the growth spurt in the third quarter, there is little other data to suggest that the economy won't return to the slow-growth, low-inflation trend sought by the Fed.

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