U.S.: Why This Recovery Feels Like a Recession

Growth looks solid, but the national mood doesn't reflect the data

Econometric models are very good at capturing how changes in interest rates or taxes will influence future economic growth. Calculating the relationship between growth and unemployment? Child's play. But modeling the effects of the national mood is where it gets tricky. And because the U.S. is facing an unprecedented crisis of uncertainty, the economic outlook has almost never been murkier.

The difficulty in forecasting based on moods is simple: How we feel doesn't always translate into how we act. Look at how consumers and businesses say they feel about the future, and the economy seems headed for a double-dip recession. Then look at the hard data on shopping and business activity, and the recovery seems on solid ground.

For example, the University of Michigan's consumer survey shows that sentiment is at its lowest in nine years. But retailers report that consumers bought many items other than cars in September, and surveys suggest they kept shopping in early October. And while business executives say they worry about what lies ahead, their companies are laying in inventories to meet future demand and gradually lifting their outlays for new equipment.

So, too, the stock market's gyrations are hard to match up with the economy's performance. The stock indexes say more about the sour national mood than about future economic prospects (table). Since the first quarter of 2001--the peak of the 1990s expansion--stock prices have dropped a staggering 26.8%, suggesting investors think the economy is collapsing. Yet real gross domestic product has grown 2.8% in that same period, and the pace has accelerated. Growth over the past year has averaged 3%, including an expected 4% annual rate in the third quarter. That's no collapse. But the split between perception and reality has made this recovery feel like continued recession.

WHAT'S BEHIND the widespread dread? Some events have loomed over the economy for a while, especially the stock market's two-year decline. And since last December, tales of corporate fraud and huge executive payouts have added to a deepening skepticism about American business practices. Recent "breaking news" headlines of abducted children, snipers, and terrorist acts abroad heighten a feeling of vulnerability.

However, the newest and most urgent addition to the national angst--and thus its role in the outlook--is that, with congressional approval now in place, a U.S. invasion of Iraq seems imminent. The progress of this war will be crucial to the outlook.

Unfortunately, this war may be unlike any past conflicts in many respects, so its effect on the economy is hard to figure. First, the U.S. may go ahead without full global support, opening questions for the dollar, financial markets, and oil prices. Second, retaliation on American soil seems likely. The major players in this economy--investors, consumers, and executives--aren't just waiting for the initial assault in Iraq: They're wondering where and when the other shoe will drop.

Thus it doesn't matter that profits are turning up or that the unemployment rate, at 5.6%, is the lowest for any first year of recovery since the 1960s. Right now, people are still concentrating on the risky intangibles of corporate scandals and war. Recent upbeat reports on third-quarter earnings from key companies, such as General Motors Corp. and Citigroup, have encouraged investors and lifted stock prices sharply. But uncertainty will continue to weigh heavily on the markets and the economy in the fourth quarter, holding back the growth of capital spending and depressing confidence, all of which could spill into 2003.

HOWEVER, WAR UNCERTAINTY may also translate into an upside. What if the war goes quickly and well? A short conflict could have important salutary effects on both the markets and the economy. Once this major source of risk is removed, stock prices might well soar, business plans could move forward, and consumers will no doubt feel better about pumping up their spending.

A key driving force here is that oil prices would likely plummet. Not only would the current war premium in petroleum prices evaporate, but if Iraq's oil fields are quickly reopened and the nation is free to re-enter world oil markets at its full potential, then prices could also dip lower in the long run. Iraq holds the world's second-largest proven oil reserves. Oil prices are currently more than 60% higher than they were at the start of the year, a factor that has helped to slow global growth this year.

BUT THAT'S A BIG "WHAT IF." For now, steadfast consumers remain about the only source of demand in the U.S., a factor that makes both the U.S. and global economies vulnerable to some unforeseen shock. Thanks to consumers, U.S. import growth has accelerated sharply this year, helping to buoy foreign economies. And consumers keep heading to the malls even as they tell pollsters how depressed they are.

To be sure, consumers' monthly spending patterns have been erratic all year, and that was true again in September. Retail sales fell 1.2% last month, but the decline was concentrated in autos, after carmakers had removed their sales incentives. Excluding autos, retail sales rose 0.1% in September, the fourth monthly increase in a row (chart). Real consumer spending on goods and services probably grew at about a 4% annual rate in the third quarter. And weekly surveys of stores indicate that October sales are rising as well.

Car buying may be set to pick up. Car deals had boosted sales sharply early in the summer so that vehicle sales for the entire third quarter averaged an annual rate of 17.8 million, the best quarterly rate in a year. Now, with car dealers having slashed their inventories of 2002 models, car companies have already rolled out a new round of sales deals for October.

Shrinking car inventories were mainly responsible for the 0.1% dip in August business inventories. Excluding autos, inventories held by manufacturers, wholesalers, and retailers ended a 15-month contraction in April. Since then, they have grown 0.4%, but sales are up more than twice as fast. In fact, inventories throughout the economy are exceptionally lean. The ratio of stockpiles to sales fell to a record low 1.34 in August, far below its 10-year trend (chart). That means inventories at many businesses are too low relative to demand, a situation that bodes well for future orders and output.

However, the will to expand inventories, supplies, and payrolls--so crucial to taking this recovery to the next level--will depend as much on the mood of businesses as on the thickness of their order books. In the end, the order books will matter the most in convincing executives of the recovery's sustainability. But until then, the national mood will be one of waiting and worrying.

By James C. Cooper & Kathleen Madigan

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