U.S.: Production May Warm Up the First Half

But GDP and job growth will remain modest until high tech picks up

The economy is beginning 2002 in much better shape than forecasters thought possible even two months ago. Positive surprises from government reports on retail sales, industrial production, and housing are leading economists to revise their real gross domestic product forecasts upward. The data also support the notion that the recession ended in December or January.

Bear in mind: This recovery won't have the oomph normally associated with an upturn. Economists now expect real GDP growth of about 1 1/2% in the first quarter. That's better than the 0.4% the consensus projected in December, when BusinessWeek surveyed 59 forecasters, but much of the additional growth will come from a slower pace of inventory drawdowns, not from surging demand.

Moreover, the economy won't grow fast enough to help the labor markets much. The only good news there is that jobless claims have fallen back from their spike after September 11 and that their current level suggests the pace of layoffs is easing (chart).

The recovery also does not mean the Federal Reserve will raise interest rates soon. The January price indexes show that inflation remains tame. And continued gains in productivity, plus wide gaps in industrial capacity and the labor markets, will keep price pressures at bay, even as the economy grows. Consequently, the Fed can take its time shifting monetary policy from extreme accommodation to relative neutrality.

PERHAPS THE BEST NEWS from the latest economic reports was the January data on industrial production. Total output fell only 0.1%, its best showing since July. Factory output was flat, also the best performance in six months. Those numbers may not sound encouraging, but manufacturers have been in recession since late 2000. The data suggest that the factory sector is finding a bottom from which to start its recovery.

Production of consumer goods, for instance, is almost back up to where it was a year ago. That's because consumer demand for motor vehicles and other goods and the housing industry remained healthy during the recession, and they are still growing in early 2002. Weekly store surveys show that retail buying through mid-February is running above its January averages. And housing starts in January rose 6.3%, to an annual rate of 1.68 million.

January's unusually warm weather lifted construction activity, so starts are sure to fall back in February, especially since builders have reported fewer sales and less buyer traffic for the month. Those declines pushed down the National Association of Home Builders' housing market index to 58 in February, from January's 60. But both the monthly starts number and the housing market index are running above their averages for all of 2001, suggesting that homebuilding is off to a good start and probably won't be a big drag on GDP growth this year.

Equally important to the outlook is how the solid housing market will help demand for home-related goods and services. Traditionally, consumers buy the bulk of their furniture, electronics, and textiles within a year of purchasing their homes. Thus, spending on such items will do well this year, even as car sales slip now that incentives are less attractive. Look for the output of consumer goods to top year-ago levels in coming months.

Manufacturers of business equipment have a far longer way to go, but even this sector seems to have bottomed out (chart). Business equipment output rose 0.4% in January, led by a 0.6% jump in computer gear. A pickup in orders for capital goods in the fourth quarter suggests that production will keep increasing--although at a relaxed pace--in coming months.

MANUFACTURING may be turning the corner partly because inventories have shrunk so much that companies must restock shelves to meet demand. In December, inventories at manufacturers, wholesalers, and retailers fell 0.4%, the eleventh consecutive drop. The ratio of inventories to sales slipped to 1.39, from a three-year high of 1.45 hit in September.

Of course, inventory-sales ratios have been trending down for years as computerized inventory controls allow companies to keep fewer supplies and finished goods on hand and still meet production schedules and sales quotas. But even when that strategy is taken into account, inventories in December were at a low level given the current rate of sales. Most of the fourth-quarter drawdown came from autos. Detroit's financing deals pushed sales up to record levels, which cleared out vehicles from dealers' lots.

Other industries may still have to whittle their stock levels before production schedules are increased. The sector to watch in this regard will be high tech. Excessive inventories are what got computer and telecom-equipment makers in hot water in late 2000, so paring stock levels is paramount. So far, tech inventories have fallen sharply, but they are still too high compared with the weak demand for computer and electronic products. Although manufacturing may have finally stopped contracting, the factory sector can't launch a true recovery until the tech sector starts to grow.

ALTHOUGH a better-than-expected recovery is welcome news, one downside is sure to be an increase in inflation fears, which could rattle the bond market and put pressure on the Fed. After all, prices typically begin to rise after a recovery takes hold. But this recession is anything but typical, and inflation should stay low in 2002. In January, consumer prices for all goods and services edged up a small 0.2%. Excluding food and energy, core prices also rose 0.2%.

Any inflation worries will be focused on the runup in service inflation (chart). Over the past 12 months, core service prices have increased 4%, led by gains in shelter, health care, and education. But with consumer demand for services easing up, the rise in service prices will very likely start to moderate this year.

Plus, extremely low goods prices will offset some of the rise in service inflation. Goods prices are actually down in the year ended in January as rebates cut the cost of a new car. But in the longer run, U.S. goods producers won't be able to raise prices because their merchandise must compete against imports which, thanks to the strong dollar, have gotten cheaper. And since factories are using only 72.7% of their capacity, manufacturers will not have to worry about production bottlenecks and supply shortages, which usually cause costs to rise.

True, capacity will very likely inch up this year, but demand won't grow robustly enough to create any production problems. Even so, the data in early 2002 have reshuffled expectations for the first quarter. Instead of a weak economy, the numbers point to fairly solid growth this winter. Better still, that strength could carry into the second quarter.

By James C. Cooper & Kathleen Madigan

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