U.S.: Growth Is Still Too Fast To Satisfy The Fed

Despite market turmoil, demand--and the risk of rate hikes--is still high

With the economy now more than a quarter of the way into 2000, is there any sign that growth is slowing down to a pace that would please the Federal Reserve and allay the fears in the financial markets that more rate hikes are in the offing? Nope, not yet.

Oh, sure, first-quarter growth is bound to come in below the fourth quarter's blistering 7.3% annual rate, reflected in the Commerce Dept.'s latest revision to real gross domestic product. But right now, economists generally expect that growth last quarter was in the range of 4.5% to 5%. That's hardly a pace that would bring smiles to Fed policymakers.

More important, the top-line number on first-quarter GDP will disguise the fact that domestic demand for everything from cars to copy machines to construction is actually accelerating, led by rambunctious consumers. Based on data so far, Business Week estimates that domestic demand grew at a 6.5% rate last quarter, up from 5.9% in the fourth (chart).

Some slowdown in demand does seem likely this quarter, if only because consumers need to catch their breath after boosting their spending at a dizzying 5.5% clip over the past year. Confidence wavered a little in March, and higher gas prices are sure to cut into discretionary income. Also, recent stock market volatility could have a sobering influence.

EVEN SO, WHY HAVEN'T domestic buyers sunk under the weight of the Fed tightening which began last June? More than borrowing costs, two other factors have powered spending over the past year: exceptionally strong job markets and the wealth effect of soaring stock prices. One, or both, of those influences will have to show clear signs of waning before you can expect any lasting slowdown in overall demand.

So far, though, every indicator points to tighter, not looser, labor markets, and while stock prices have been exceptionally volatile, there is still considerable stimulus from past wealth gains left in the pipeline. Only a protracted period of market weakness will dissipate the wealth effect on spending.

Investors got an idea of what a severe market correction might look like when stock prices rode the roller coaster on Apr. 4. The Dow Jones industrial average swung 700 points between its high for the day and its low, only to close down 47 points, or 0.4%. The tech-heavy Nasdaq composite was down 75 points, or 1.8%. The drops left the broad Wilshire 5000 index, a good proxy for the wealth effect, about flat for the year, but it remains up about 16% from a year ago.

And keep in mind it's accumulated wealth--not one-day volatility--that will determine future consumer spending. From the fourth quarter of 1998 to the final quarter of 1999, household net worth increased by 13.4%, according to economists at Goldman, Sachs & Co. Using the standard rule of thumb, that's enough to add at least 1.5 percentage points to annual growth in real consumer spending.

Wealth gains have had a clear impact on car sales. March sales added up to an annual rate of 17.9 million, down from the phenomenal 19 million pace in February. For the quarter, sales averaged a record 18.2 million, up from 16.9 million in the fourth quarter (chart).

That surge is a big part of why overall consumer spending sped up in the first quarter. Given data through February, real outlays for the quarter are likely to post a growth rate of 6.5%. However, vehicle sales were helped by dealer incentives and so are unlikely to maintain their first-quarter pace. That means overall consumer spending is likely to slow a notch or two in the second quarter. Moreover, weekly retail surveys suggest a slower pace of nonauto buying in March, possibly foreshadowing cooler growth this quarter.

THE MOST SURPRISING SECTOR in the first quarter was construction. February outlays for new homes, business structures, and government projects rose 1.5% in February, after gains of 2.2% in January and 2% each in November and December. That's the strongest four-month growth since 1984. Real construction outlays, which feed directly into certain GDP categories, might have risen at a 15% annual rate in the first quarter. In particular, housing appears to have made a solid contribution to GDP growth.

In addition, business investment in new equipment likely rebounded strongly from what was probably a Y2K-related slowdown in the fourth quarter. Through February, shipments of capital goods rose at an annual rate of about 14%, a sharp reversal from a slight decline at yearend. A similar speedup is evident in the monthly data on the output of business equipment.

Persistent domestic demand is powering the industrial sector. The nation's purchasing managers reported that their business index in March slipped to 55.8%, from 56.9% in February. But a reading above 50% signals that the factory sector is expanding.

One important bit of news in the buyers' report was the continued rise in prices paid for materials. The price index jumped to 79.8%, the highest reading in five years (chart). The survey said that "Comments from purchasing managers this month focused on rising prices." And while soaring oil prices were noted, higher prices were also reported for certain metals, electronics, containers, and freight charges.

OF COURSE, NOT ALL SEGMENTS of the economy contributed to growth last quarter. Government spending, which soared an unusually large 9.3% in the fourth quarter, probably did not add anything to growth.

The chief drag, however, is sure to be foreign trade. The January trade deficit was far greater than the fourth-quarter average, even after adjusting for pricier oil, whose biggest impacts will not show up until February and March. A wider trade gap could easily subtract 1.5 percentage points from overall growth in GDP. That's the chief reason why the top-line GDP number will be less than the growth in domestic demand.

Another possible subtraction might have come from slower inventory growth. Some of the Y2K-related precautionary buildup in the fourth quarter was expected to be reversed in the first quarter, but, so far, the monthly data show little slowdown in the pace of stockbuilding.

U.S.: Growth Is Still Too Fast to Satisfy the Fed
U.S.: Growth Is Still Too Fast to Satisfy the Fed
U.S.: Growth Is Still Too Fast to Satisfy the Fed

Overall business inventories in January grew at about the same pace averaged in the fourth quarter, unadjusted for inflation. And through February, stock levels in manufacturing were rising faster than in the fourth quarter. Still, some of that rise reflects higher oil prices that have inflated inventory values.

The Commerce Dept. won't report first-quarter GDP until Apr. 27. And key data--especially the Apr. 19 trade report--will factor into the final calculations. But the considerable data already available show that businesses and consumers used much of the winter to keep spending. Until domestic demand cools off, look for more frowns at the Fed.