U.S.: Few Signs of Life through the First Quarter

Consumers and inventories are canceling each other's effect on GDP

As 2001 draws to a close, an economic recovery is more forecast than fact. The latest data show that industrial activity is still falling, retailers are bemoaning lackluster sales, and businesses are laying off workers in the face of poor profits and dim prospects for the future. Economists in general believe that the recession will end in the first quarter of 2002. That prediction, however, is based mainly on policy efforts and hopeful indicators that bode well for the outlook. So far, hard evidence of better times remains elusive.

Nevertheless, some tangible signs are cropping up that suggest the fourth quarter will be the worst period of this recession. First, the drag from the tech-sector collapse is beginning to wane as output losses get smaller. Second, the mood of consumers is starting to pick up following the events of September 11. After plunging in October, the University of Michigan's index of consumer sentiment edged up in December for the second month in a row. The major consumer-attitude measures from both Michigan and the Conference Board remain well above the levels plumbed during the 1990-91 recession.

Most important, the impact on economic growth of the dramatic inventory liquidation in 2001--necessitated by previous bulges in autos and tech equipment--may reach its nadir by yearend (chart). Keep in mind that, in the accounting of gross domestic product, the change in inventories determines the level of GDP, but it is the magnitude of that change from quarter to quarter that determines the inventory sector's contribution to GDP growth. For example, if businesses cut their stockpiles by $80 billion in one quarter and then by a lesser $60 billion in the following quarter, that counts as a $20 billion increase in the latter quarter's GDP.

THE FOURTH-QUARTER LIQUIDATION will clear the way for a pickup in output in 2002. It also points to a key development for the fourth and first quarters: Consumer spending and inventory growth are neutralizing each other's effect on GDP growth, leaving the weakness in capital spending and exports to dominate the economy's performance. Consequently, real gross domestic product in the fourth quarter is likely contracting as fast, or perhaps faster than, its 1.1% drop in the third quarter.

Watch the industrial sector to see this dance between consumers and inventories. Industrial activity started to fall six months before the recession began in March, and manufacturing has accounted for the lion's share of this year's job losses. Industrial production gave the first signal that demand was softening, and it will be a key barometer for the recovery.

In November, the output data were mildly encouraging. Even though industrial production fell 0.3% during that period, with manufacturing output down 0.2%, the drop-off was much smaller than in recent months.

Moreover, the report brought good news from the tech and auto sectors, where inventories needed substantial realignment with sales in 2001. The November 0.6% drop in output of tech equipment continued the string of smaller tech-output losses that began in July. Tech equipment makers may be getting a better grip on their inventories: Their inventory-sales ratio has fallen for two months in a row. Clearly, the tech sector is still in trouble, but its drag on economic growth in the second half of 2001 was far less than in the first (chart).

FOR AUTO MAKERS, generous incentives worked like magic to cut inventories and boost sales. The huge consumer response to zero-rate financing cleared out dealer inventories so fast that November stockpiles were the lowest for that month since 1993. Auto makers responded to dealers' empty lots by boosting production by a steep 6.4% in November, and more increases may be on the way. Even if sales in December fall as expected, carmakers will still have to initiate some inventory replacement, says Ward's Automotive Reports. Already, some manufacturers are upping their production plans for the first quarter.

That will be a plus for first-quarter real GDP. For the fourth quarter, though, autos will lead yet another huge liquidation in overall business inventories. The third-quarter liquidation was the largest in the postwar era, but the fourth-quarter decline will most likely be even greater--a big subtraction from GDP growth.

That was clear from October's inventory data, which showed a record 1.4% plunge in stocks held by manufacturers, wholesalers, and retailers. But it was the 2.8% drop in retailers' inventories, reflecting a steep decline in autos, that told the story. Because of cars, inventory liquidation is set to subtract one to two percentage points from fourth-quarter GDP growth.

CONSUMERS, MEANWHILE, are doing their best to add to GDP growth. Retail sales surged 6.4% in October and only fell back 3.7% in November. Almost all of the swing reflected October's record pace of car sales followed by more modest sales in November. When that turnaround--and the price-related drop in gasoline sales--is excluded, a more stable trend in store-buying emerges (chart). Indeed, fourth-quarter real consumer spending is growing at a rate of 2% to 3%.

However, that pace will barely be strong enough to offset the drag from inventories, and the only other sources of strength are government and housing. Home starts unexpectedly jumped 8.2% in November, although much of the gain was influenced by unusually mild weather. The nation's homebuilders reported that sales activity in December picked up, but housing's contribution was likely small in the fourth quarter. Add in declines in capital spending and a slightly wider trade gap, and real GDP will almost certainly post its second straight decline in the fourth quarter.

Will the first quarter also see a decline in real GDP? Expected increases in government spending--for rebuilding efforts and defense--will probably offset another decline in capital spending. Weather will determine housing's performance this winter, while the slowdown in demand, both in the U.S. and overseas, will likely hold the trade deficit steady.

Again, that leaves consumers and inventories as the key to the first-quarter outlook. Most assuredly, car sales will drop this winter, possibly resulting in the first decline in consumer spending of this recession. But with car production scheduled to pick up, the thrust from vehicle inventories will turn positive--and may be large enough to enable the total inventory change to add slightly to economic activity.

Considering all of these factors, real GDP may well be about flat in the first quarter. In normal times, that would be a very disappointing performance. Since it will follow two consecutive drops in activity, though, consumers and businesses alike will welcome an economy that is simply holding its own, with the promise of better times not far away.

By James C. Cooper & Kathleen Madigan

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