U.S.: Despite Scary Data, the Recession Could Be Mild

Better inventory control and falling imports will help soften the blow

The tenth U.S. recession since World War II is starting to leave its mark. But despite some horrendous-looking data of late, especially from the labor markets, there is still every reason to believe that the downturn will be mild by historical standards.

Certainly, timely and aggressive policy moves will cushion the downturn, but they are only part of the story. Businesses had made extensive adjustments to the slowdown in demand prior to the events of September 11. Much of the heavy lifting had already been done, helping to make the economy less vulnerable to the shock. The Commerce Dept. reported that third-quarter real gross domestic product declined at a mere 0.4% annual rate. Had the terrorist attacks not occurred, growth would have been well into positive territory, and analysts would now be focused on recovery, not recession.

Technology and globalization also have given the economy some potent shock absorbers. First, more efficient inventory-management systems have already drastically reduced excess stockpiles. The $50.4 billion rate of liquidation in the third quarter was even faster than it was in the second quarter, making the total liquidation of the past three quarters the largest in postwar history (chart). In coming quarters, a slower pace of liquidation will add to economic growth. And because tighter security has slowed distribution this quarter, many businesses are laying in precautionary supplies in excess of what they would normally hold.

Moreover, imports are now so much larger than exports that a falloff in U.S. demand will actually narrow the trade deficit. Last quarter's GDP numbers show that exports dropped by a sharp 16.6%, but imports plunged 15.2%, resulting in a narrower trade gap that added to the quarter's GDP growth. Tighter border security is sure to slow import growth even more in coming months, although lower imports will worsen downturns in economies around the world.

FOR NOW, THE RECESSION looks anything but mild, and fourth-quarter real GDP is set to fall at a faster rate than it did in the third. The economic data coming in are some of the first post-September 11 readings, and they reflect the initial shock effects on consumer and business activity. The numbers prove that households and companies did exactly as expected when a crisis hits: They froze. Retail buying and factory orders for new equipment fell off a cliff. Consequently, profits plummeted, and job losses soared. The flurry of bleak news is why economists expect the Federal Reserve to cut interest rates for the tenth time this year when policymakers meet on Nov. 6.

However, the true weakness in the economy is not as bad as these alarming September and October data suggest. Businesses are rattled right now, but as they get a better handle on current and future demand, their ordering and hiring rates will come out of the deep freeze.

Prior to September 11, companies had made enormous progress toward cutting their labor costs and maintaining productivity gains. Employment costs for the year ended in September were up 3.9%, lower than their 4.7% pace of a year earlier. Moreover, the GDP data suggest that productivity in the third quarter posted a solid advance, because businesses cut hours worked much more rapidly than output fell.

Businesses have been realigning their inventories and capital spending all year to match up with diminished prospects for demand. Then, in September, orders for new capital equipment plunged 11.4% (chart). Shipments, which tumbled 3.2%, were far below their third-quarter average, meaning that capital spending in the fourth quarter is already in a deep hole. Business outlays for new equipment and construction fell 11.9% in the third quarter, and they will likely post another double-digit decline this quarter.

CONSUMERS also are still shaken up. They are obviously concerned about the war, both at home and abroad, but their biggest worry on the economic front is jobs. Consumer confidence fell sharply in October for the second month in a row. Household expectations of future conditions worsened, but consumers also noted that present conditions are deteriorating rapidly. Importantly, the share of households who say jobs are hard to get jumped to 20.7% last month, the most in almost five years (chart).

Keep in mind that consumers hold the key to the severity of this downturn. The September plunge in retail buying limited consumer spending to a gain of only 1.2% in the third quarter, the slowest pace in eight years, and fourth-quarter outlays will likely decline. However, not all household news is bad. Confidence is down, but it remains well above the lows plumbed in past recessions. Also, consumer buying, particularly for motor vehicles, rebounded somewhat in October--perhaps out of a sense of patriotism, perhaps as a result of 0% financing.

THE PROBLEM IS that recent reports are only fueling consumers' job jitters. In September, the Conference Board's index of help-wanted advertising in newspapers around the U.S. fell to the lowest level since the severe 1981-82 recession, although this index may have been pushed down in recent years by increased Internet job listings. Through October, the four-week average of new claims for unemployment benefits edged above 500,000 per week, matching the peak hit during the mild 1990-91 recession. Still, during the 1981-82 downturn, claims topped out at 674,000.

The claims numbers are a good example of how the data have deteriorated after the attacks. The next few weeks will bring equally disastrous news on more layoffs, industrial production, and factory orders. However, as the initial impact of September 11 wanes, the data will not look as dire as they will in the days just ahead.

Until September 11, the weakness in the job markets and in the economy generally was not sufficiently severe or broad to qualify as a recession, and the building blocks of a recovery were falling into place. Now, the National Bureau of Economic Research, the official arbiter of business cycles, will most likely take into account that past weakness when it sits down to determine when this recession began. That means the start data of the downturn is likely to be set much earlier this year.

Recessions eventually do end. Already, the economy is benefiting from the aggressive policy in place prior to September 11. Lower interest rates and tax rebates are helping businesses and consumers shore up their finances, and that reliquefication will pave the way for stronger demand later on. Add to that the structural advantages of better inventory management and open trade. These shock absorbers will smooth some of the bumps ahead, and they will play a significant role in ameliorating the pain of this downturn.

By James C. Cooper & Kathleen Madigan

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