U.S.: Will a Rainy Second Quarter Make for a Sunny Second Half?

Drastic inventory reduction clears the way for future output gains

Recession? What recession? The surprising news that the U.S. economy grew at a not-too-shabby 2% annual pace in the first quarter, a pickup from 1% in the fourth quarter, went a long way to allay fears that the 10-year expansion was going down the tubes.

So are we out of the woods? Not yet. Second-quarter growth in real gross domestic product is likely to be weaker, because some of the factors that boosted first-quarter GDP, such as a sharp narrowing in the trade deficit and a lift from government outlays, are not offering the same support this quarter. Consumer spending and housing also are likely to add less growth, even as capital spending by businesses, especially for high-tech equipment, continues to decline. Add it up and the best prospect is for little, if any, growth.

Looking toward the second half, though, the GDP data show that a huge roadblock has been largely cleared. Because demand held up fairly well, inventories were drawn down drastically (chart), especially in the auto sector, eliminating a big chunk of the excess stockpiles that had been choking many businesses and leading to production cuts and massive layoffs. The recession in manufacturing may be bottoming out, as suggested by the recent uptick in the purchasing managers' index.

With the inventory adjustment well under way, the outlook right now boils down to a tug-of-war between the plus from consumer spending and the minus from business investment in new equipment. It's a struggle that will keep the Federal Reserve in a rate-cutting mind-set this spring and summer, despite the first quarter's stronger-than-expected growth. The Fed will be especially sensitive to weakness in the labor markets and its potential to drag down consumer spending.

THE FED WILL ALSO keep a sharp eye on capital spending. In various speeches, Fed Chairman Alan Greenspan has voiced concern over the problems in the tech sector. But the overall first-quarter growth surprise highlights a key point about technology and its role in the economy: In the long run, the tech sector is altering the economy's structure and enhancing its growth potential by lifting productivity. But in the short run, while tech clearly exerts more influence on the business cycle, other sectors, such as consumer spending, are still far more important.

Even so, business spending is worth watching because the capital spending boom fueled the productivity gains that blessed the U.S. economy with low inflation. That boom is now fading. Total business investment in equipment fell at a 3.3% annual rate in the fourth quarter and at a 2.1% rate in the first, as businesses adjusted to life in the slow lane. Real business investment for tech equipment dropped at a 6.4% rate last quarter, the first decline in 10 years.

As bad as that number looks, the decline was much smaller than had been suggested by the monthly data on tech orders and shipments. The reason: Those data are not adjusted for prices, and tech prices began to fall once again in the first quarter at an increasingly rapid rate (chart). In particular, prices for computers and peripheral items plunged at a 28.5% annual rate, the largest quarterly drop in almost three years.

As a result, the dollar value of tech outlays fell at a 12.8% annual rate, but the real volume declined by only half that much. Price-cutting is hammering tech companies' profits, but in terms of GDP growth, it is limiting the downdraft from tech weakness and speeding up this sector's efforts to cut excess inventories. Indeed, tech inventories dropped sharply in March.

IF PRICE-CUTTING to clear out inventories sounds familiar, it should. It's the strategy used by carmakers who plied buyers with generous incentives. After averaging an annual rate of 17.2 million in the first quarter, carbuying in April slipped to a still-strong 16.6-million rate. Thanks in large part to the auto adjustment, business inventories in the first quarter fell for the first time in almost a decade.

In fact, the swing from inventory accumulation of $55.7 billion in the fourth quarter to a $7.1 billion liquidation in the first was the largest in the postwar era. It subtracted 2.5 percentage points from overall growth, and yet the economy still managed to grow at a 2% rate. Of that nearly $63 billion swing in price-adjusted stockpiles, retail autos contributed $29 billion.

Now, Detroit is building cars again. Based on the industry's second-quarter production schedules, auto output is set to contribute at least a percentage point to the quarter's GDP growth. That follows drastic production cuts that subtracted 0.9 points and 0.7 points from growth in the fourth and first quarters, respectively.

BUT OTHER INDUSTRIES were slashing stock levels as well, and the success of those efforts helps explain why the purchasing managers' index of industrial activity has bounced off its low point. The index edged up to 43.2% in April, from 43.1% in March and from January's low of 41.2%. That's still below 50%, meaning that factory activity continues to lose ground, but the rise in the purchasers' index of new orders looks encouraging for future output gains (chart).

Clearly, some businesses are lifting orders to meet resilient consumer demand. Household outlays rose at a 3.1% rate last quarter, and consumer spending's contribution to GDP growth has more than accounted for overall economic growth in each of the past three quarters. The single most important factor for the consumer outlook is just how stalwart shoppers will remain in coming months as the labor markets soften.

The extent to which job markets sag will depend on an often-ignored dark feature of the New Economy: Businesses can boost their output more easily by increasing productivity than by hiring new workers. With full employment now generally believed to be consistent with GDP growth in the 3.5% to 4% range, a growth slowdown to the 1% to 2% range will open up considerable slack in the labor markets. Already, jobless claims in early April tipped over the key 400,000 mark, a level that suggests little, if any, job growth.

Moreover, with wages and benefits up 4.1% from a year ago, as measured by the employment cost index, workers are becoming more expensive for businesses to hold on to, even as pricing power remains limited and profits get squeezed. But on the plus side, pay is rising faster than inflation, providing solid support for household spending.

When the books are closed on 2001, the second quarter may well prove to be the weakest quarter of the year. Both consumer and business outlays are under intense pressure from softer job markets and profits, respectively. However, the first-quarter growth surprise, in addition to the Fed's aggressive rate-cutting and the Bush Administration's prospective tax rebate, offer the best hope yet that a recession will be averted and that growth is set to pick up in the second half.

By James C. Cooper & Kathleen Madigan

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