U.S.: Something Else for Greenspan to Worry About

Capital-spending cuts are idling factories, prompting another Fed move

Consumers are still out shopping, and builders are using more construction supplies to put up new homes. Yet manufacturing remains in the grips of recession, with output sinking and layoffs rising. What gives?

Blame these apparent inconsistencies on the complexities of this business cycle, many of which are related to the new influences of technology--both positive and negative. This slowdown began when consumer spending cooled, forcing businesses, especially auto makers, to make adjustments in their inventories.

Now comes Phase Two: Companies are cutting costs and reining in outlays for equipment. That means the inventory problem has shifted to the makers of high-tech products--computers, semiconductors, peripherals, and telecom equipment--and these industries are slashing output. It also means that capital spending will be a big drag on second-quarter economic growth.

The problems of the capital-goods sector were very much on the minds of Federal Reserve policymakers when they met on May 15. As expected, the Fed cut its federal funds rate by a half-point, to 4%. The Fed's accompanying statement noted that consumer spending and housing have held up well, although activity has flattened recently. However, it said that investment in capital equipment "has continued to decline" and that weak profits and uncertainty over the outlook "seem likely to hold down capital spending going forward."

THE FED HAS TRIMMED rates by 2 1/2 percentage points in only 4 1/2 months, the most aggressive easing under Chairman Alan Greenspan and one of the boldest series of cuts ever. But the Fed probably isn't finished, since policymakers remain more concerned about economic weakness than about inflation pressures.

Indeed, the statement downplayed both the first-quarter drop in productivity and inflation worries, saying that "with pressures on labor and product markets easing, inflation is expected to remain contained" (chart). However, the likelihood of more intermeeting cuts seems to be waning. Unlike the statement following its March meeting, the Fed did not mention the need to "monitor developments closely," words that have often preceded moves between meetings.

Further signs of economic weakness will most likely justify another Fed move at its June 26-27 meeting. And softness will probably remain centered in manufacturing. The inventory overhang in the vehicle sector, just 4% of factory output, started the manufacturing downturn last fall. The drop in auto production subtracted 0.9 percentage points from real GDP growth in the fourth quarter and 0.7 points in the first quarter.

Now it's tech's turn to deal with excess inventories and output cuts. Total industrial production fell 0.3% in April, its seventh decline in a row. Factory output alone slipped 0.3%, also the seventh consecutive drop. But production of tech equipment fell 1% in April, the fourth big drop in as many months (chart), and tech output in the first quarter was revised down sharply.

THE GREAT DEBATE right now is whether this sector, some 10% of manufacturing, is in such dire straits that it will drag down the rest of the economy. On the surface, the answer seems to be no. Even excluding the steep declines in tech output so far this year, factory production would still be down by almost the same amount for each month, suggesting that the output weakness goes beyond just tech equipment.

The rapid tech slowdown, however, is an example of how swiftly companies now react to shifts in the economy. Green-span has noted that better information and new technologies have shortened the lead time for equipment delivery and enabled companies to adjust their capital spending more quickly to demand shifts. So inventory adjustment of tech gear should take a matter of months, not quarters.

This compression makes the adjustment feel more severe and results in a sharp rise in layoffs, which shakes consumer confidence. So, too, warnings about profit shortfalls, such as Cisco's in mid-April, cause jitters among investors. That's why, even though the inventory correction directly affects just a small segment of the economy, it has large spillover effects.

Luckily, the adjustment to stock levels, especially in the tech sector, is already well under way. Total business inventories fell 0.3% in March after a 0.4% drop in February. Stock levels of tech equipment plunged 3% in March on top of a 0.8% loss in February. The inventory drop, coupled with a 2% gain in March shipments, pushed the inventory-sales ratio from 1.21 in February to 1.15 in March. That's a good start to readjusting inventories, but the ratio is still above the 1.03 record low of September, 2000, suggesting production will fall further in coming months.

Keep in mind that tech manufacturers aren't just adjusting to demand problems but also face overcapacity in their own sector. New production capacity was growing at a 50% annual rate in mid-2000. For April, the rate had fallen to about 20%, and it will go lower, since companies need to balance their supply capabilities with the new, slower pace of demand.

HOW MUCH WILL DEMAND SLOW? Consumers hold the key. So far at least, they remain committed to spending, though at a more modest pace. Retail sales jumped 0.8% in April, but the March data were revised down to show a 0.4% drop instead of the 0.2% loss originally reported. Retail buying began the second quarter 2% above its first-quarter average, suggesting that real consumer spending is growing much more slowly than the 3.1% gain of the first quarter.

The April retail increase, however, was better than expected and bolsters the argument that consumers can keep this expansion going. Higher gasoline sales--mostly the result of rising prices--contributed only one-tenth of the total percentage advance in April.

Although the Fed did not mention costlier energy explicitly in its May 15 statement, it is always on Greenspan's list of concerns, since it boosts production costs and cuts household buying power. In early May, the average price for a gallon of gas was $1.74, up from $1.44 in March (chart), and prices are expected to keep rising this summer.

Higher fuel prices are also pushing up the top-line inflation numbers, but there is scant evidence that companies are able to pass along their higher costs to customers. Total consumer prices rose 0.3% in April and are up 3.3% from a year ago. Core prices, which exclude food and energy, increased 0.2% in April, for a slower yearly gain of 2.6%.

One of the key differences in this business cycle is that low inflation is giving the Fed the room it needs to act aggressively. Now that the economy is safely past Phase One, the steep rate cuts, already in the pipeline, will provide strong support against the negative effects of Phase Two and pave the way for stronger growth.

By James C. Cooper & Kathleen Madigan

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