U.S.: Tax Money Will Soothe the Second Half

But second-quarter GDP growth may be the worst since the last recession

Sometimes good economic policy is like profitable investing: Timing is everything.

Although the data are still sketchy, there's a growing chance that the second quarter's real gross domestic product could be shrinking, leading to accelerating job losses and pronouncements of recession. But just as those ominous tidings begin to lead the evening news later this summer, tax rebate checks will start to show up in mailboxes, and the Federal Reserve's superaggressive rate cuts will hit. Right now, the second-half outlook hinges on the crucial idea that this double dose of government stimulus will more than offset the drags currently holding back the economy.

There is plenty of bad news to go around. New data show that stockpiles of tech equipment are still far above desired levels (chart) owing to cutbacks in capital spending by businesses. And orders and shipments of capital goods continued to plunge in April, indicating further downward pressure on tech output. This means that equipment investment will be the chief weakness in second-quarter GDP, falling even faster than it did in the first quarter. The problems in the tech sector were one reason Fed Chairman Alan Greenspan warned in his May 24 speech that "the period of subpar growth is not yet over."

Also clouding the second quarter: Many GDP components that added at least moderately to growth in the first quarter are not providing the same cushion again. For example, housing is flattening out, the trade deficit is unlikely to repeat its sharp first-quarter narrowing, and consumer spending is growing at about half of last quarter's 2.9% pace. Add it all up, and the second quarter will very likely be the weakest since the 1990-91 recession. After that, will the economy be able to right itself?

ON THAT SCORE, the outlook is hopeful. First, the liquidation of excessive inventories in the first quarter turned out to be even greater than first reported. The Commerce Dept.'s revised GDP data show growth at 1.3% instead of 2%, mainly reflecting an $18.9 billion drop in inventories. That drawdown helps to clear the way for future production. Second, despite dismal job news, consumers have not cut back on their spending and actually showed increased confidence in May.

Finally, the biggest lift to growth will come from the rapid and aggressive actions of the Fed and the unusually fortuitous timing of the Bush Administration's tax plan. Over the next year, tax cuts alone will total about $100 billion, or about one percentage point added to GDP growth. The impact will be especially profound in the third quarter, when some $40 billion in rebate checks, along with about a $15 billion cut in taxes withheld from paychecks, hit consumers' wallets.

If shoppers were to spend anywhere from half to all of the money in that quarter, it would add between 1.6 and 3.6 percentage points to the annualized growth rate of that quarter's real consumer spending, assuming 2% inflation. Realistically, because of lags, the spending impact will stretch into the fourth quarter. That means the back-to-school shopping season, as well as the important holiday season, will benefit handsomely.

THE TAX CHECKS should fortify the consumer sector, which has remained resilient during these sluggish times. In April, real consumer spending edged up a modest 0.2%. And in May, the Conference Board's index of consumer confidence rose. After plunging from October to February, the index seems to have stabilized at a level far above those usually associated with recessions (chart).

The May results show that while households are concerned about the current job situation, their feelings about future job prospects are a shade more optimistic. Overall expectations for the six months have turned up. June confidence seems likely to register another increase in the wake of the favorable tax-cut details.

Consumer spending and the job outlook will be critical to economic activity in the third quarter. But that outcome depends increasingly on what happens in the corporate sector, as consumers react to businesses slashing labor costs and capital spending in an effort to repair their dismal profits picture.

In its first-quarter GDP revision, Commerce also reported on profits economywide. No surprises there. Corporate earnings, adjusted for seasonality and for Commerce's concept of depreciation and inventory values, fell from the previous quarter for the second quarter in a row. Earnings of nonfinancial companies dropped for the third consecutive quarter.

More important, profit margins, measured as profits per unit of output among nonfinancial corporations, are under severe pressure. In addition to the squeeze from higher energy prices, rising labor costs are taking a toll (chart). For example, since the second quarter of last year, when margins peaked, unit labor costs at nonfarm businesses have risen more than twice as fast as prices. For nonfinancial corporations, the disparity has been even greater.

THE LACK OF CASH FLOW, along with reduced expectations for future demand, is cutting into capital spending. April orders for nondefense capital goods plunged 5.2% from March, starting second-quarter bookings far below their first-quarter level. Moreover, April shipments of capital equipment dropped 4.7%, suggesting a sharp contraction in equipment spending in the second-quarter GDP data. Equipment demand is especially weak in the tech sector, where April shipments of computer and related products fell 5.1%, the fourth monthly decline in a row, and April new orders plunged 8.8%.

This weakness is causing the serious backup in inventories of tech equipment. So far this year, tech inventories have barely grown, but shipments have plunged more than 15%. As a result, the ratio of inventories to sales has skyrocketed, especially in relation to the downward trend in that relationship over the past decade. This implies that the current level of stockpiles is far from optimal, and that further production cutbacks in the tech sector will drag down total industrial orders and output in coming months.

Businesses will also be under pressure to cut their labor costs. So far this year, healthy pay growth has supported consumer spending. But layoffs are rising, and companies are trying to hold the line on wage gains.

The outlook boils down to a tug-of-war between Corporate and Household America. Which one will ultimately determine the path of the economy? Households won Round 1, but in the second quarter, the negative impacts from business cutbacks are swaying the balance. However, strong policy stimulus will end up benefiting both sides in the second half. And heading into 2002, consumers and businesses will be propelling the economy forward.

By James C. Cooper & Kathleen Madigan

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