U.S.: Up Ahead for the Economy: A Chilly Spring

Inventory data don't look promising, and the stock market remains weak

In a winter as harsh as this one, it's normal to start yearning for signs of spring. Likewise, the weak economy is prompting a search for better times. Some recent data announcing an imminent turnaround look like crocuses, but there is no overwhelming cause for optimism just yet. The weakness in business activity may be close to bottoming out, although the economy, especially manufacturing, may not see a rebound in output until the second half.

The reason for caution is that factory inventories ended January in worse shape than expected. And while the February purchasing managers' report showed a glimmer of improvement (chart), the manufacturing recession continues. The reassuring note in the outlook is that demand has not collapsed under the weight of falling confidence and stock prices. Car sales and orders for capital goods have been stronger recently, and healthier demand will support a factory recovery.

Even so, the economy remains fragile amid the uncertainty of the stock market and the resulting worries among portfolio-owning consumers. A weak stock market may yet be the expansion's Achilles' heel, since it could erode both consumer and capital spending. Investors were especially disappointed that Federal Reserve Chairman Alan Greenspan did not appear more eager to lower interest rates when he spoke to Congress on Feb. 28.

However, investors seem to have it backwards. If the economy were in dire need of lower rates, that would be a signal that the expansion is going down the tubes, and investors would have to be even more concerned about future growth and profits. Recent data, which have been a bit more encouraging, are why Greenspan did not give the markets what they wanted. Another confidence-bolstering rate cut seems likely at the Fed's Mar. 20 meeting, but it will probably take some sudden weakness in the data to provoke a move before then.

THE NUMBER 1 STRUGGLE among manufacturers is to realign production with the slower pace of demand and, in the process, flush out excess inventories. The news for January stock levels was not good. Stockpiles at factories jumped 0.7% after falling 0.1% in December--a drop which raised hopes that industrial companies were quickly cutting their overages down to size.

The January increase throws some cold water on those hopes, especially since the factory problem is widening. Although auto makers have cut inventories sharply in each of the past three months, they still have a long way to go before dealer stocks are down to normal levels. Companies that make capital goods are also behind in their efforts. In particular, inventories in the information technology industries are still rising strongly. That suggests more cutbacks in the production of capital goods in coming months.

Some good news: New orders for capital goods outside of defense and aircraft jumped a broad 5.6% in January, and orders for information-processing equipment posted a strong gain, after declining in both November and December.

But stock levels are still excessive. That shows up in the rising ratio of inventories to sales, meaning that output and demand remain out of alignment. The ratio for all manufacturing rose to 1.35 in January, the highest reading in two years (chart). Adjusted for the ratio's declining trend, which reflects better inventory management, the inventory problem is the worst since the 1990-'91 recession.

BUT THOSE ARE JANUARY DATA. Resilient consumers are helping cut the problem down to size. In particular, strong February car sales cleared out dealers' lots, which may partly explain the small uptick in the February purchasing managers' index. The PMI has always been significantly influenced by ups and downs in auto production.

This composite of output, orders, employment, inventories, and speed of deliveries edged up to 41.9% last month, from 41.2% in January, the first increase in a year, indicating that activity among industrial companies is not deteriorating as rapidly as it was. The index, however, remained below 50%--the dividing line between expansion and recession in manufacturing--for the seventh month in a row.

Another hopeful February finding: Companies were less downbeat about their inventory situations. In answer to a special survey question, fewer purchasing executives--22% vs. 26% in January--said inventories were too high. That percentage had been on the rise since last August.

DESPITE FALLING CONFIDENCE, households are not so worried about the future that they have stopped buying. Higher energy prices lifted January outlays for goods and services by 0.7% from December, so the price-adjusted rise was only 0.2%. Still, real outlays in January grew at an annual rate of 1.5% from their fourth-quarter level, suggesting that consumer spending is on track to post another moderate gain in this quarter, following the fourth quarter's modest 2.8% rise.

Costlier energy has been a drain on household buying power in recent months, but its effect on household budgets may be overstated. From 1992 to 1997, energy expenditures amounted to 4.8% of household aftertax income. When energy costs plummeted in 1998, that share dropped to only 3.8%. Since then, the share has risen steadily, but in January it stood at the same 4.8% level that existed earlier in the expansion.

That rise has clearly created an adjustment for households, but it's not as if energy was presenting an enormous new drain on buying power. Moreover, oil prices are now down almost $10 per barrel from their $37 peak last September, and futures prices for natural gas are coming down. When these lower commodity prices work their way to the retail level, households will see their buying power lifted again.

Consumers seem especially willing to take advantage of a good deal on a new car when they see one. Sales of cars and light trucks rose to an annual rate of 17.4 million in February, up from a surprisingly strong 17.1 million rate in January (chart). Car buying had dropped to a 15.4-million rate in December.

Car sales are buoyed in part by dealer incentives. That could rob some sales from the spring months as well as diminish profits for the Big Three. Nevertheless, the strength shows that households are willing and able to make commitments on long-term purchases, and that excess auto inventories are shrinking, helping to clear the way for future output.

Sustained spending by consumers may well be the expansion's most crucial line of defense. Resilient demand for products will help to limit the downside risks to capital spending and profits, and it will help manufacturers to reduce their excess inventories faster. So far, consumers seem up to the task.

By James C. Cooper & Kathleen Madigan

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