U.S.: The Slowdown Takes A Rain Check

It's still likely in 1999, as profits soften, but it will develop only gradually

A lot of economists must be scratching their heads about now. Ever since last summer's global financial market turmoil, forecasters generally have been expecting some degree of slowing in the U.S. But so far, there is little evidence that the economy has lost much, if any, of its first-half vigor. In fact, the Federal Reserve's aggressive easing in recent weeks, which already has Wall Street partying again, adds stimulus that will start flowing into demand in the first half of 1999.

Clearly, the second half of 1998 isn't shaping up to be much of a slowdown. Based on the Commerce Dept.'s revisions to gross domestic product, the economy grew at a solid 3.9% annual rate in the third quarter--compared with 3.7% in the first half. Third-quarter GDP was revised up from an already surprisingly strong 3.3% pace, mainly because overall demand grew faster than first estimated.

And in the fourth quarter, consumer spending is on a track to match--or exceed--the third quarter's energetic 4.1% growth rate, and homebuilding is still booming. Consumers have recovered some of their confidence (chart), partly because the Dow Jones industrial average has regained all of the 1800 points it lost this summer. And the Fed says that banks are as willing as ever to make consumer loans. True, slower inventory growth is likely to cut into GDP growth this quarter and foreign trade will still be a drag. But with domestic demand still so solid, it will be hard to call that a slowdown.

DESPITE THIS MOMENTUM, slower growth in 1999 is still the most likely scenario, and the ongoing profits recession is the reason. Commerce says that third-quarter operating profits fell from the year before for the first time in six years, despite the strong economy (chart). Earnings will remain under pressure as long as the growth in prices and productivity are not strong enough to offset rising labor costs.

Weak profits, plus costlier credit, are bound to put downward pressure on capital spending and hiring plans. Indeed, initial claims for unemployment benefits have ticked up in recent weeks, suggesting some loosening in the labor markets. That will eventually cap income growth. Moreover, the drag on manufacturing from weak exports will continue, if not as intensely as in 1998.

But because of the economy's surprising resilience, any slowdown in 1999 is likely to develop gradually. Consider that, for all the hand-wringing over Asian fallout this year, especially on Wall Street, U.S. economic growth has barely slowed. Even if fourth-quarter GDP growth is half the third quarter's pace, the economy will advance 3.3% this year, only a half point below the spirited 3.8% showing in 1997.

Credit that to booming domestic demand, led by an expected 5% growth rate in consumer spending this year. That kind of striking growth is almost never seen this far into an economic expansion. The powers behind it: the strongest job market in a generation, low inflation that has boosted real wages, and accommodative financial conditions, including low interest rates and a bull market in stocks.

THEREIN LIES A DILEMMA for the Fed. The central bank has cut interest rates three times since Sept. 29, with the purpose of assuring stability in the financial markets. In its recently released minutes of the September meeting, the Fed said the move would "cushion the effects of more restrictive financial conditions." But that cushion might act as a trampoline to catapult the already strong consumer and housing sectors, partly by giving banks even more incentive to lend to consumers, and partly by refueling the bull-market psychology on Wall Street.

In fact, banks show a constant willingness to make consumer loans even as they tighten their lending standards for business borrowing. The Fed's latest quarterly survey of senior loan officers says that more than a third of U.S. banks have tightened their borrowing requirements for large and middle-market companies. That's the highest share reporting tighter standards since 1990. Bank loans to businesses are growing rapidly, because many companies now find bank loans cheaper than borrowing on the credit markets. Banks, however, are getting pickier. For consumer loans, on the other hand, the survey shows "little evidence of any changes in lending practices." And consumer installment debt, which surged $8.4 billion in October, has sped up this year.

EASIER FINANCIAL CONDITIONS are one reason why consumer spending shows no sign of letting up. October car-buying and retail sales were strong, and November retail surveys show continued gains. Also, the Conference Board's index of consumer confidence rebounded nearly 7 points in November, to 126. And why shouldn't it? Stock prices have recovered, the impeachment of President Clinton is less likely, and the Fed is cutting rates. Consumers' feelings about the future snapped back sharply, as the index of expectations scored its largest monthly gain in five years.

And in a separate survey, the Board reported that despite recent uncertainties, American families plan to spend an average of nearly $500 on holiday gifts this year. The increase from $465 in 1997 is the largest in the survey's 12-year history, and the Board concludes that the holiday buying season could be "a blockbuster."

Some of those purchases will go into all the new homes that are being built and sold. Housing starts jumped 7.3% in October, the largest monthly advance in more than a year. That means starts began the quarter well above their third-quarter average.

The strength in starts should not be surprising, given the wildly upbeat assessment of market conditions offered by builders. The National Association of Home Builders' housing market index, which gauges builders' views on present and expected sales as well as buyer traffic through model homes, surged to a record 78% in November from October's 73% reading, which was the previous record (chart). The index suggests that new-home demand continues to rise.


To be sure, the risks of a sharp slowdown have not gone away completely. Weak exports are still hammering manufacturing, and capital spending on new equipment and buildings is already slowing. Factory orders for durable goods declined a broad 1.7% in October, and bookings for nondefense capital goods dropped 7.2%. Both order levels are below their third-quarter averages.

Another big risk would be a new round of financial-market turmoil, especially if the profits recession worsens. That could squeeze business even further, and another stock-market swoon could throw a scare into consumers. But barring that scenario, the 1999 economy may end up looking a bit better than many folks expected a few months ago.

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