U.S.: The Stars Are Aligning for a Second-Half Pickup

Lower inventories and oil prices will help, but Greenspan is cautious

Betting on a second-half turnaround? So far, the tip sheet doesn't offer much guidance. And Federal Reserve Chairman Alan Greenspan sounds wary, despite the Fed's official forecast, which implies a pickup in the third and fourth quarters.

The latest data are running hot and cold. Consumers are still spending, and housing is holding up. But industrial production is falling, as are payrolls. Plus, the tech wreck, still scattered across the information highway, will not be cleaned up until next year.

Outside of tech, however, the economy is firming up because two of the biggest drags on first-half growth are easing. First, businesses are better aligning their inventories with their sales, clearing the way for pickups in factory orders and output. Second, lower prices for gasoline and other fuels are acting like a giant tax cut for both consumers and businesses. In the second half, these two pluses will work in tandem with the policy stimulus already in the pipeline from lower interest rates and taxes.

The Fed's panel of forecasters all expect some degree of turnaround. The central bank's latest outlook for economic growth for all of 2001 centers around the 1.25% to 2% range (table). If second-quarter growth in real gross domestic product is zero, as generally expected, that forecast implies second-half growth at an annual rate of 1.9% to 3.4%.

THAT SOUNDS PRETTY GOOD, but the forecast of the policymaker who matters most may be at the low end of that range. In his semiannual report to Congress on monetary policy on July 18, Greenspan said plainly that "the period of subpar economic performance, however, is not yet over, and we are not free of the risks that economic weakness will be greater than currently anticipated, and require further policy response."

And in his off-the-cuff remarks during the Q&A, Greenspan showed even more caution, suggesting another rate cut is likely at the Fed's Aug. 21 meeting. "I don't know whether or not you would describe what's going to occur as a rebound," he said, suggesting that any turnaround will be slow in developing. He also said that the bottom may just now be forming. That might imply that the Fed chief thinks the first half's weakness is extending into the third quarter.

Even Greenspan, however, acknowledged some improvement, saying the data that had once been unrelentingly negative "have now turned mixed." One area that looks encouraging is inventories. May stockpiles held by manufacturers, wholesalers, and retailers were unchanged from April, when they fell by 0.2%, and the May ratio of inventories to sales fell to 1.42, the lowest since last October.

More progress was made in June. The National Association of Purchasing Management reported that only 14% of the industrial companies it surveyed said that inventories were "too high," down sharply from a peak of 26% in January. June was the first month since last fall in which more purchasers said that inventories were "too low" than "too high."

However, the progress in eliminating excess stockpiles is slow and uneven (chart). Auto makers have made exceptional headway. Earlier this year, the supply of domestically made vehicles had soared to 90 days. But by the end of June, dealer inventories were down to a comfortable 61-day supply.

Tech stockpiles are another story. Yes, they are shrinking, but shipments are falling faster. Since March, inventories of computers and electronic products, including peripheral gear, telecom equipment, and semiconductors, have fallen 4%. But shipments have plunged 12%. Consequently, the ratio of inventories to sales in May was still rising, hitting a three-year high of 1.54.

INVENTORIES AREN'T the only problem for the industrial sector. It's also getting clobbered by export weakness, partly due to the superstrong dollar. So don't expect much, if any, turnaround in factory production or payrolls. In June, manufacturing output fell 0.8%, the ninth monthly decline in a row. Second-quarter factory output fell at an annual rate of 5.9%, after dropping at a 7.9% rate in the first quarter.

For tech equipment alone, output shrank at an annual rate of 19.4% last quarter, three times faster than the first-quarter decline. Overcapacity remains a huge problem. Despite cutbacks and plant closings, tech capacity grew at a large 22.8% annual rate last quarter.

Excluding tech, the factory news is slightly better. Output declined at an annual rate of 4.3% in the second quarter, but that was half the size of the first-quarter drop. The biggest plus was a quarterly swing in auto output, from a 27.2% plunge to a 35% surge.

AS GREENSPAN NOTED, consumer spending has been resilient. And demand has helped along the inventory adjustment. More importantly, households will have even more going for them in the second half than in the first half. That includes not only tax rebates and lower interest rates but lower energy prices as well.

Since peaking in mid-May, gasoline prices nationally have dropped nearly 20% (chart), and further declines seem likely. If gas prices stay at about $1.35 per gallon, the drop would add some $30 billion to the purchasing power of incomes this quarter. That rivals the $38 billion in tax rebates in terms of economic stimulus.

The positive impacts from cheaper fuel are already showing up. The consumer price index rose 0.2% in June, with a 0.9% drop in energy costs. The CPI could decline in July, as the full impact of falling fuel costs works its way through. Moreover, the drop in gasoline prices made June retail sales look softer than they really were. Overall sales rose 0.2% from May, but excluding gas stations, retail sales were up 0.4%.

The problem is that consumer demand can only go so far in correcting the inventory problem in tech equipment. Those goods are more sensitive to demand by businesses, which are in the middle of sharp cutbacks in their capital spending. Greenspan said: "Investment spending ultimately depends on the strength of consumer demand for goods and services." But since most of that demand will be satisfied out of existing inventories, look for continued downward pressure on tech-equipment output in coming months.

The good news for businesses is that lower energy costs will go straight to the bottom line--just when profits need the help. The Fed has estimated that up to a quarter of the increase in costs for nonfinancial, nonenergy businesses in the fourth quarter reflected a larger energy bite.

The new positive supports don't mean a second-half pickup is a sure thing. But even amid all his caution, Greenspan couldn't help but remark: "It is notable how well the U.S. economy has withstood the many negative forces weighing on it." With some of those negatives now waning, the odds of a second-half turnaround are improving.

By James C. Cooper & Kathleen Madigan

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