U.S.: Can The New Economy Handle This Stress Test?

An inventory correction will hit growth hard in the first half

In several important ways, the New Economy is behaving a lot like the older version. Despite new technologies and globalization, it still has its ups and downs. It's still subject to shifts in Federal Reserve policy. And most important for the coming months, it still must endure old-fashioned inventory corrections.

The emerging inventory adjustment was uppermost in Fed Chairman Alan Greenspan's mind during his brief but crucial comments on the economy in his Jan. 25 congressional testimony. He said bluntly to Senator Olympia J. Snowe (R-Me.) that "we are observing the beginnings of what is probably a major inventory correction." The belief is the underpinning of his remark to Senator Paul S. Sarbanes (D-Md.) that economic growth right now is "very close to zero."

That's why Greenspan & Co. took "rapid and forceful" action, as the Fed described it, when they cut the federal funds rate by a half point on Jan. 31, on the heels of the surprise half point reduction on Jan. 3. Given that unusually urgent language, and given that the Fed's outlook is still tilted toward concerns about economic weakness, more cuts cannot be ruled out. The Fed is able to act aggressively, partly because recent data show that labor costs and inflation remain tame.

WHAT WORRIES GREENSPAN is that a classic temporary inventory correction may trigger a full-blown recession. As usually happens, the inventory adjustment is already hammering manufacturing. Economic growth fell to a slim 1.4% in the fourth quarter, reflecting sharp slowdowns in both demand and output of goods, even as the service sector remained strong (chart). But as inventory growth slows further, real gross domestic product will take a big hit in the first half, and it might even contract in the first quarter.

Greenspan's biggest concern is that the pain of the inventory correction will severely jolt the confidence of consumers and businesses. The manufacturing recession has already led to layoff announcements and earnings warnings that have rattled consumers' outlook. With demand already slowing, a sharp curtailment in outlays because of fears about the future could tip the overall economy into an outright recession (chart).

For two years, industrial companies both in the U.S. and abroad pumped out goods to satisfy consumer and business demand that was growing at a boom rate of 6% or more. That demand was concentrated in goods, especially big-ticket durable ones such as autos and machinery, and it was powered in large part by the wealth effect from soaring stock prices.

Now, because of past Fed tightening and a substantially reduced wealth effect, those days of booming demand have come to a sudden halt. The growth of domestic spending in the second half of 2000 fell off to 2%, the slowest two-quarter pace in eight years. The upshot: Companies must realign their inventories and production with a more down-to-earth pace of demand.

That process has barely begun. In the fourth quarter, inventory growth slowed, but only by enough to subtract 0.2 percentage point from overall GDP growth. A big chunk--but not all--of the inventory drawdown will come in the auto industry, where demand has fallen steeply. Auto makers responded by cutting output sharply, and the drop in vehicle production, by itself, subtracted a full percentage point from GDP growth in the fourth quarter. But that still wasn't enough: Auto inventories kept rising. A combination of further output cuts and sales incentives in the first half will be needed to fix the problem.

One interesting feature of the New Economy inventory cycle is that technology could be both boon and bane. Computerized inventory systems have helped to damp potential economic swings by ensuring that excessive inventory buildups are smaller and more quickly eliminated. But that rapid elimination could also compress the correction, causing a larger hit to economic growth over a shorter period of time, a point that the Fed emphasized in its rate-cut statement.

ARMED WITH ITS RATE CUTS, the Fed is fighting the slowdown on two fronts: one is the reality of softer demand and output, the other is perceptions of economic weakness. Those perceptions, and their potential harm, were in full view in the January plunge in consumer confidence. The Conference Board's index tumbled 14.2 points in January, to 114.4. It was the largest one-month drop since the 1990-91 recession.

For now, at least, the perception seems to be worse than the reality. Consumers say that present conditions for business activity and employment, while somewhat softer, remain very strong by historical standards. As for future business conditions, job opportunities, and income prospects, those are another matter. Households' increasingly downbeat expectations have driven down the overall confidence index. The index of households' expectations not only dropped sharply but set a seven-year low, hitting levels that are typically seen prior to recessions.

But consumers' behavior doesn't always dovetail with the way they say they feel. Despite their worry, weekly surveys of January retail sales show very upbeat results, and a new round of generous sales incentives from car companies is generating what early reports suggest will be a strong month for car buying. Moreover, sales of new single-family homes in December jumped 13.4% to the second-highest level on record.

BUSINESS SENTIMENT, as it affects capital spending plans, is another key area of concern. In the past, inventory corrections have often eroded business confidence to the point where companies sharply curtailed capital spending. And in this expansion, capital spending has been a key contributor to economic growth.

The threat is compounded by capital spending's weakened supports. Businesses will spend less if they expect the economy to grow at only half its previous rate. Plus, with profits slowing, internal funds to finance projects are scarcer, even as funds from external sources such as banks, credit markets, and the stock market are less available or more costly.

U.S.: Can the New Economy Handle This Stress Test?
U.S.: Can the New Economy Handle This Stress Test?
U.S.: Can the New Economy Handle This Stress Test?

Businesses are already trimming their capital budgets, especially for traditional industrial machinery and equipment (chart). High-tech outlays are growing at a slower rate, but that's down from an unusually rapid clip in late 1999 and early 2000. The more that demand for capital and consumer goods slows, the greater the required inventory adjustment.

The inventory correction will be a stress test for the economy in the first half, and especially in the first quarter. If companies can make the adjustment to a slower pace of demand without killing off confidence or the stock market, then the outlook for the second half will be much improved. And interest-rate cuts will likely be the tonic that gets consumers and businesses through the ordeal.

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