U.S.: Will Booming Capital Spending Keep Inflation At Bay?
Amid all the attention this year given to Wall Street, the Federal Reserve, U.S. consumers, and other key areas of the economy, one sector has received short shrift: capital spending. The fact is, after a slowdown in the second half of last year and early this year, business investment in new equipment and buildings is rebounding strongly, and that resurgence should continue into early 1998. The bonus, at least in the long run, is that more investment will help the economy become less inflation-prone, though the short-run impact is more iffy.
This year's upsurge is not just high tech, where outlays continue to soar. Businesses are shelling out billions for more traditional machinery, as well as new industrial plants, warehouses, and office buildings. After slowing to a single-digit growth rate in the fourth quarter of 1996 and the first quarter of 1997, capital spending jumped at a 14.6% annual rate in the second quarter. And when the Commerce Dept. reports on second-quarter gross domestic product on Oct. 31, look for another sizable advance (chart).
Strong corporate outlays, coming on top of a powerful rebound in consumer spending, are a key reason why the GDP data will show robust growth in overall demand. September retail sales rose 0.3%, a bit stronger than expected, and sales for both July and August were revised upward. Real consumer spending in the GDP numbers appears to have surged at an annual rate of between 5% and 6%, possibly the strongest showing in 5 1/2 years. Brawny demand is fueling renewed fears of Federal Reserve rate hikes, amid increased concern about the possibility of rising inflation in 1998.
THE PRODUCER PRICE INDEX for September brought those fears into focus, as the overall index jumped 0.5%, and the core index excluding energy and food rose 0.4%, the most in nearly two years. However, some temporary forces appear to have lifted prices, including hikes in tobacco prices and car and truck prices, which should reverse course in October.
Booming capital spending should allay some of those inflation worries, because over the long haul it adds to production capacity and lifts productivity, helping to relieve some of the constraints that expanding demand is placing on existing production facilities. But in the here and now, as Fed Chairman Alan Greenspan pointed out in his market-rattling congressional testimony on Oct. 8, current labor market imbalances may be tough to alleviate simply through increases in capacity.
In particular, Greenspan cautioned against expecting too much from the economy's new high-tech slant. That is especially true with regard to the growing strain that demand is placing on the labor markets, as labor demand outstrips the growth rate of the working-age population. These pressures, Greenspan said, "reflect biology, not technology."
He said that reducing the recent two-million-plus annual rate of job growth to the one-million rate consistent with the trend in population growth would require a full percentage-point increase in the trend pace of productivity, but such a shift is rare in the annals of business history, he said.
RARE, YES, BUT BUSINESSES are making a spirited effort in that direction. The surprising feature of this year's pickup in capital spending is the contribution of non-high-tech outlays (chart). In the second quarter, purchases of transportation equipment, led by a surge in aircraft, rose at the fastest quarterly rate in 3 1/2 years, while sales of industrial machinery posted the largest gain since 1984. Other equipment used in construction, mining, and agriculture is also growing faster. Low-tech outlays, some 54% of all equipment spending, are up nearly 7% from a year ago, after the growth rate had fallen below zero early last year.
Moreover, outlays for new buildings are also gaining momentum. After declining in the second quarter, inflation-adjusted construction spending through August is rising at a 15% annual rate from the second-quarter level. This reflects strength in both industrial and office buildings, which should continue. In particular, office vacancy rates are still trending downward from their very high levels of earlier in the expansion. Vacancy rates in suburban areas are down to about 10% from more than 20% in 1991. The drop in downtown areas, though, has been less pronounced. Also, commercial rental rates have been rising.
To be sure, high-tech equipment continues to grow at a rapid clip, although the pace has eased a bit in recent quarters. Through the third quarter, outlays for computers and other information-processing equipment likely grew about 19% from a year ago, but in early 1996, the pace was 26%. High tech's share of equipment outlays has surged from just over 30% in early 1991, to 46% in the second quarter.
WHAT'S BEHIND THE BOOM? Companies are responding to a host of positive influences on capital spending. One of the most important is the economy's faster pace that began late last year. Economists call it the "accelerator" effect, which links business investment to current and past growth in overall output. That factor alone suggests that the speedup in business outlays has further to run, especially with consumer spending so strong (chart). Indeed, third-quarter orders for nondefense capital goods through August are rising at a 24% annual rate. If that pace holds up, it would be the fastest in two years.
Also, production capacity is very tight, increasing the incentive of companies to add new machines and buildings. In August, manufacturers, utilities, and mines were using 83.9% of their output capacity, the most in two years. As for service producers, the unemployment rate in services averaged 4.9% in the second and third quarters, the lowest since early 1990.
At the same time, financing is especially attractive. In fact, with profits so strong, companies have more leeway to finance their projects internally, without going to the credit markets. BUSINESS WEEK's early-bird tally of profits for the third quarter show earnings up a surprisingly strong 18% from a year ago.
Through the second quarter, the ratio of cash flow at nonfinancial corporations to outlays for fixed investment remained close to 1, a favorable level and about the average for the past three years. Also, equity financing is attractive right now relative to debt, given such high ratios of stock prices to earnings. A high price/earnings ratio lowers the cost of equity financing.
No one would argue that expanding business investment doesn't bode well for future trends in productivity growth and inflation. However, as Fed Chairman Greenspan suggested, the near-term impact is a continuing topic for debate. And in the mean time, the Fed may well decide that bumping up interest rates a notch is a policy that is better safe than sorry.