U.S.: The Second Half Should Be Healthier

But the strength of the rebound depends on how quickly tech recovers

Life with a broken leg is tough. A part of your body has a painful injury, and any forward movement is severely impaired. But your life isn't at risk, and in time, the cast will be removed.

The tech sector is this economy's broken leg. The latest numbers on real gross domestic product show that investment on information technology took a tremendous fall in the second quarter, plunging at a 19% annual rate. The rest of the economy, meanwhile, hobbled along. Real GDP grew at a 0.7% pace after a 1.3% advance in the first quarter. Although revisions may change the numbers, so far the U.S. economy has not yet contracted for one quarter, let alone two--the usual definition of a recession.

Instead, the second-quarter data, plus revisions to data going back to 1998, augur well for the outlook. Consumers are still spending. They have more income and savings than was previously thought. And businesses drew down inventories for the second quarter in a row, setting the stage for a factory recovery. But better economic growth in the second half will be slow to take hold. In particular, the manufacturing sector is still stuck in recession (chart).

At the same time, the cost pressures from wages and benefits are easing, due in part to some loosening in the job markets. That will give the Federal Reserve more leeway to cut short-term interest rates, probably at their Aug. 21 meeting. And slower wage growth may calm some of the recent inflation jitters in the bond market. Even so, incomes are still outpacing inflation, meaning that rising household buying power will be a significant support for the second-half upturn.

THE REBOUND'S STRENGTH will depend on how quickly the fractured tech sector heals. Overall business investment on equipment dropped at a 14.5% annual rate last quarter and subtracted 1.5 percentage points from total GDP growth. A large portion of the falloff was in spending on information-processing equipment and software as companies worked down their huge inventories of computer and related equipment.

But revisions to capital spending from 1998 to the first quarter of 2001 show that the boom in tech investment was not as huge as first thought. Using the Commerce Dept.'s new numbers, BusinessWeek economists calculate that companies invested about $106 billion less in info-processing gear over the past three years, or about 2% less of the capital stock. As a result, the glut in tech capacity is not as big a problem as previously estimated (chart).

That's good news for manufacturing, since that sector will not come out of its downturn until capital spending perks up. Another welcome development in the second quarter: Inventories fell by $27 billion for the second consecutive quarter on top of downward revisions to inventory growth in 2000. For businesses outside the tech sector, stock levels are now better aligned with sales. Industrial orders and production should bounce back.

But not just yet. In June, durable-goods orders fell 2%, suggesting demand hasn't turned around. And in July, the purchasing managers' index indicated that the industrial sector continued to contract at the start of the third quarter. The PMI fell to 43.6% in July, from 44.7% in June, dragged down by declining orders, production, and employment.

THE DOWNWARD REVISIONS to both tech spending and inventories were not offset by upward revisions to other sectors. That means over the past three years, real GDP grew at an annual rate of 4%, instead of 4.3%. Less output suggests that productivity growth over the past few years will be revised down when the data are released on Aug. 7. And if companies were slightly less efficient than first thought but compensation still grew, then unit labor costs were higher and profit margins got squeezed. Little wonder then that Commerce lowered its figures for corporate profits.

But Commerce revised up personal income and lifted the savings rate, especially in 2000. The saving rate is now put at 1% for last year, instead of -0.1%. That means consumers have more of a cushion than analysts thought, which explains why consumers keep on spending even in light of rising layoffs.

Job jitters are taking a toll on consumers' psyches, however. The Conference Board's consumer confidence index slipped to 116.5 in July from June's 118.9 (chart). Consumers' assessment of current economic conditions fell to 152 from 156.8 in June. The gloomier spirits probably reflect not only layoff announcements but also disappointment that the heralded cut in tax withholding did not show up in many workers' paychecks.

Expectations for the economy over the next six months fell slightly in July from June, but last month's reading was much higher than the average for the second quarter. The board says that "consumers are cautiously optimistic that the economy will rebound later this year."

Since expectations correlate closely to growth in consumer spending, optimism about the future means spending should contribute to economic growth. That's especially likely since wages and salaries continue to rise. Compensation increased 0.9% in the second quarter from the first, according to the Labor Dept.'s tally of employment costs for civilian workers. That pushed compensation up 3.9% above its year-ago level. The increase worked out to a 3.7% gain in wages and salaries and a 4.5% boost to benefits.

WAGES AND BENEFITS are both growing at the weakest pace in 1 1/2 years, and that slowdown should help the profits outlook, since labor costs are about two-thirds of total business expenses. Going forward, businesses must try and offset the rise in labor costs by increasing productivity somehow.

But while the yearly pace in wages and salaries has slowed, the 3.7% increase was above the 3.4% rise in consumer prices, so real wages are rising. And lower energy costs will slow inflation further in coming months. That means pay gains will generate bigger increases in buying power in the second half.

For the consumer sector as a whole, future pay raises are likely to be big enough to offset the fall in personal income due to layoffs. And with taxpayers now receiving their rebate checks, the consumer sector looks in good financial shape to keep the economy expanding at the same time that inventory adjustments should be less of a drag on growth.

That leaves capital spending as the biggest impediment on the economy. To be sure, the tech recovery process will be painful, and the economy will face risks in carrying along a sector that is basically dead weight. But like a broken limb, the tech sector will heal eventually. And when the cast is finally off, expect tech to work with the rest of the economy to move the expansion forward.

By James C. Cooper & Kathleen Madigan

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