U.S.: The Economy Looks Ready To Take A Breather

But it's still too early to tell how long the pause will last

The economy galloped through the winter like Real Quiet in the home stretch of the Kentucky Derby. So it isn't surprising that growth is set to slow this quarter--if only enough for consumers, homebuilders, and businesses to catch their breath. Just how much will growth cool off, though, and will any slowdown last into the second half? The answers are crucial for monetary policy and Wall Street.

The goods-producing sector, which typically leads the economy's short-term swings, holds the key. In particular, did the Asian drag on exports bottom out in the first quarter, or is there further deterioration to come? How much will consumers rein in their outlays for autos, homes, and other durable goods? And especially critical, by how much will companies scale back their rapid pace of inventory building? The data on these questions are still sketchy, but they suggest that some degree of slowing is already in progress.

However, any second-quarter downshift will have to continue in the second half to ease the growing pressure on the labor markets and assure that the Federal Reserve keeps policy on hold. On that note, the data offer little help. In fact, the supports under domestic demand--from income growth to confidence to financial conditions--remain solid. And even though labor costs increased less in the first quarter than they did in the fourth quarter of last year, the annual growth trend continued to rise last quarter (chart).

A 5.9% SURGE in domestic demand was the power behind the first quarter's surprisingly strong 4.2% advance in real gross domestic product. The economy has grown at an annual rate of 3.8% for the past two years. That's the best two-year performance in nine years, and back in 1989 inflation was 4% and rising. In the first quarter, the price index for gross domestic product showed a 1.4% inflation rate, the lowest rate since 1965 and down from 2.3% two years ago.

Exceptional first-quarter gains in consumer spending, up 5.7%; residential construction, up 17.7%; and business investment in high-tech equipment, up an astounding 45.8%, led the way. The overall increase in GDP was especially stunning given that Asian weakness widened the trade deficit to a postwar record. By itself, that larger gap subtracted 2.2 percentage points from the quarter's growth rate.

In the second quarter, at least two of those first-quarter demand leaders are set to slow, perhaps substantially. Homebuilding fundamentals are still strong, but the data will look weaker, because measures of activity last quarter were inflated by unusually warm weather. Also, the surge in high-tech investment will not be repeated. It was the largest quarterly increase in two decades and by itself accounted for more than a third of last quarter's GDP gain.

Consumers are also unlikely to repeat their first-quarter binge, but the slowdown may not be substantial. Weekly retail reports show strong gains for April, and motor-vehicle sales shot up to a 15.5-million annual rate, from a 15.1 million average in the first quarter.

Weakness in Asia will keep the trade gap wide this quarter. But any further large deterioration is unlikely. Some of the trade deficit's first-quarter widening was a one-time occurrence, reflecting an often cited data quirk that inflates the first-quarter deficit. So trade is likely to play a comparatively neutral role in growth this quarter.

AT THE BEGINNING of the second quarter, though, manufacturing was still feeling the chill from Asia. The National Association of Purchasing Management's index of industrial activity--comprised of survey responses on output, orders, employment, inventories, and delivery times--fell to 52.9% in April, from 54.8% in March. The index of export orders showed some weakness in foreign demand, but not as much as the record low in January (chart). The rebound may signal that the Asian drag is bottoming out.

Looking to the second half, Asia is far from the chief concern of the NAPM's membership. That distinction goes to labor costs. The employment cost index, a government gauge of wages and benefits, rose a less-than-expected 0.7% in the first quarter, down from the fourth quarter's 1% increase. However, the annual trends in both wage growth and benefits are still up. Not surprisingly, cost pressures are the greatest in the Midwest and the South, where job markets are the tightest. Labor costs will remain in an uptrend until the labor markets start to loosen up.

THE FIRST QUARTER was also strong because businesses did not slow their inventory building as expected. Instead, real inventories grew at a $77 billion annual rate, more than the $74 billion in the fourth quarter.

Three factors, though, argue that the inventory buildup is not sustainable. First of all, stockpiles have been growing faster than sales for four quarters now (chart). Second, in the past, large inventory accumulation lasted only about a year, as this cycle has already. And third, the extra stockpiling was a response to the sizzling demand of the past year. But with spending expected to slow this quarter, businesses will adjust their inventory levels accordingly.

That may already be happening. In March, factory stock levels grew 0.3%, after a 0.7% jump in February. And the NAPM said that companies reduced inventories in April. Moreover, the purchasers' outlook shows that businesses expect to cut their inventories throughout the year to keep them in line with sales.

What was interesting about the first-quarter buildup was that a sizable chunk of the goods came from overseas. U.S. factory production grew at only a 1.8% pace last quarter, while merchandise imports surged 10.2%. Since final sales of goods rose at a 7.9% pace, much of the import surge apparently wound up in warehouses.

Of course, inventories are notoriously volatile. In this expansion, the average quarterly swing in stock levels has been about $15 billion, or nearly one percentage point of GDP growth. The good news is that--since imports were likely a big contributor in the first-quarter buildup--the inventory slowdown in the second quarter will lead to a dropoff in import growth. That means the subtraction to GDP growth from inventories will be partly offset by a reduced drag from imports.


The mix of first-quarter growth--robust domestic demand and inventory building counterbalanced by a weak foreign sector--bolsters the idea that the economy is slowing this quarter. But it's too early to tell if the spring break is just a pause or the start of another soft landing. The outcome is crucial to business executives who, like the nation's purchasers, are concerned about the rising trend in labor costs and the shortage of skilled labor. That obstacle to business expansion and profit gains won't go away unless this racehorse economy slows to a trot for more than one quarter.

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