U.S.: The Only Double-Dip Will Be on Your Ice Cream Cone

Thanks to resilient consumers, the recovery isn't likely to peter out

After the economy burst out of the gate in the first quarter, growing at an annual rate of 5.8%, some dismal scientists warned that the recovery was destined to peter out in the second quarter. Consumers were bound to fade, they said. Well, it's not happening. Households remain the leading force in this recovery, and fears of a double-dip in the economy are now all but dead.

That's evident from the latest news on consumer spending. Motor vehicles in April sold at a pace higher than their first-quarter average. Rising applications for mortgages show housing demand is still strong. And most surprisingly, retail sales jumped 1.2% in April, the biggest gain in six months (chart). The increase in store sales suggests that real consumer purchases are on track to grow at an annual rate of 3% to 4% in the second quarter, enough to ensure another quarter of healthy economic growth.

In fact, the economy began this quarter with considerable momentum carried over from its first-quarter gallop. Industrial production rose in April, but producers are running to catch up with demand. Despite rising output, business inventories in March continued to fall, indicating more production gains in coming months. Real gross domestic product won't repeat last quarter's 5.8% surge, but it's not headed toward zero, either.

Meanwhile, inflation is benign. Consumer prices in April rose 0.5% from March, but setting aside one-time jumps in energy and tobacco products, the rise was only 0.2%. Low inflation gives the Federal Reserve plenty of leeway to keep interest rates on hold. In particular, the Fed wants to see businesses start to invest in new equipment again, the crucial last part of a balanced recovery. Policymakers are also watching how last year's bust in capital spending is affecting productivity, but Fed Chairman Alan Greenspan is now hinting that the lull may actually help productivity.

THE CONTINUED RISE in consumer spending improves the outlook in ways that go beyond just shoppers' direct contribution to GDP growth. First, the spending gains allowed businesses to sell off much of their excess stockpiles of goods, and future inventory repositioning will add to GDP growth. Second, companies are looking for a consistent upward trend in final demand before they increase their capital spending plans. Consumers account for the bulk of U.S. final demand.

That's why the surge in April retail sales was extremely good news, especially in the stock market, where investors may finally believe that this recovery has the staying power to generate future profits. The April store gains were widespread. Sales at car dealerships rose 1.9%, and higher gasoline prices boosted gas-station receipts. But even excluding those two categories, sales were still up a robust 0.9%.

Households have a lot on their minds, and those worries were supposed to hold back spending. Predictors of a double-dip pointed to higher gas prices, more unemployment, and rising debt levels as factors that would keep consumers from opening their wallets.

They have kept spending, however, because their real aftertax income is growing, on average, at a healthy 3% to 4% pace, reflecting several factors: Job growth is turning up, pay raises are outpacing inflation, and tax rates for some households have been cut. Also, except for extreme cases like Silicon Valley, home values have held up. That wealth gain has offset stock market losses while also allowing homeowners to tap their home equity for spending.

THE STEADY CLIMB in consumer demand has left some businesses with insufficient stockpiles to meet shoppers' appetites. Inventories held by manufacturers, wholesalers, and retailers in March fell 0.3% from February, while sales rose 0.3%. As a result, the ratio of inventories to sales, which dipped lower in March, is now below its long-term trend. This suggests that many businesses need to start adding to their inventories in order to meet demand. That is particularly true in wholesaling, where stockpiles are at the lowest level in relation to sales since 1997, and in nonauto retailing, where the ratio is at a record low (chart).

The need to rebuild some inventories is leading to a recovery in the factory sector. Industrial output in the nation's factories, utilities, and mines increased 0.4% in April, with manufacturing alone scoring a 0.3% advance. Those gains put industrial production on a pace to rise faster this quarter than its 2.6% annual rate of increase of last quarter. The Fed reported that in March, output gains were the broadest in five years.

AN APRIL PICKUP in production of high-tech goods suggests that companies are starting to invest in new equipment. The fundamentals under capital spending are improving: With help from consumers, expectations of future demand are brighter, enormous productivity gains are setting the stage for better cash flow, and bankers are not as stingy as they have been.

The Fed's latest survey of senior loan officers shows that the percentage of domestic banks tightening their lending standards for large and midsize companies fell sharply in April, to 25%, from 45% in the January survey. The percentage for small companies seeking loans dropped from 42% to 15%. Those are the lowest percentages in two years (chart). Plus, the spread between loan rates and banks' cost of funds fell to its narrowest point since late 1999, implying that banks are going after new lending more aggressively.

Still, the survey suggested that the capital-spending turnaround is coming very slowly. Banks said that demand for commercial and industrial loans remained weak. Every bank experiencing weaker demand for C&I loans noted that softer demand for funds to finance capital expenditures was at least a "somewhat important" reason for fewer loan requests, while more than a third said it was a "very important" reason.

Interestingly enough, Fed Chairman Greenspan does not seem overly alarmed at the capital-spending drought. In a speech on May 10, he even suggested that the slump of the past year and a half may be boosting productivity growth.

As counterintuitive as that may sound, keep in mind that a key part of technological change is digesting new technology. Studies show that efficiency can be lost when fresh technologies are implemented, because workers must spend time learning new procedures and equipment. Greenspan says that an investment lull can diminish those inefficiencies and allow the benefits of past investments to shine through. That could partly explain the recent extraordinary advance in productivity.

That gain is also lifting workers' real buying power. Add in the outlook for improving cash flow and better financing conditions, and a turnaround in capital spending is inevitable--with much of the credit going to the surprising resilience of consumers.

By James C. Cooper & Kathleen Madigan

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