U.S.: After a Soft Fourth Quarter, the New Year Should Be Happier

The Fed takes out some insurance for a stronger economy in 2003

The Federal Reserve is fed up with the toll that uncertainty is taking on the economy. That much was clear from the Fed's surprisingly aggressive half-point cut in interest rates on Nov. 6. While the move will do little to aid what promises to be a weak fourth quarter, it helps to lay the groundwork for stronger growth in 2003.

In a unanimous vote, the Fed reduced its overnight federal funds rate to 1.25% and said pointedly that "greater uncertainty, in part attributable to heightened geopolitical risks, is currently inhibiting spending, production, and employment." The action appeared to be aimed directly at shoring up business' confidence in the future. But it may be a one-shot move, since the Fed also said the balance of risks in the outlook were no longer skewed toward economic weakness.

The Fed did recognize that the economy is in a "soft spot" this quarter. However, if you look across the valley of the fourth quarter, the other side looks a lot brighter. That's especially true now because the Fed's bold action complements key economic fundamentals that will support growth in demand and output in 2003.

First, even before the Fed's latest move, businesses were starting to spend again. Third-quarter outlays for equipment rose faster than they did in the second quarter. And why not? Reports on both profits and sales last quarter were quite encouraging, and with productivity up and costs down, the outlook for further gains in earnings is improving.

Second, consumers' spending potential continues to be supported by healthy income growth. Despite the overall somber tone of the October jobs report, employment losses remain concentrated in the manufacturing sector (chart). Also, a boost from the record refinancing wave has yet to show up in outlays, and the recent upturn in the stock market is an added plus.

CONSUMER FUNDAMENTALS may not look that robust in this quarter since household spending will be suffering from a loss of momentum coming out of the third quarter. Real gross domestic product rose at a 3.1% annual rate last quarter, and household spending on goods and services grew 4.2%, the strongest showing of the year. But the monthly pattern showed the gains were front-loaded in the quarter. Spending rose 0.9% in July, faded to a 0.2% increase in August, then fell 0.6% in September. An expected post-incentive crash in car sales accounted for much of the slowdown, but spending on other items tended to trail off as well.

Consequently, spending began the fourth quarter in a deep hole, especially since October car sales fell to an annual rate of 15.3 million after averaging 17.6 million in the third quarter (chart). Even if outlays grow a solid 0.3% or 0.4% in both November and December, household spending will struggle to provide any lift at all to fourth-quarter economic growth. That's the chief reason why growth in real gross domestic product this quarter will look weak.

However, just as the third quarter's strength was front-loaded, the fourth-quarter's weakness may be front-loaded as well. That would indicate an improving performance heading into 2003. For one thing, past trends in mortgage applications and stock prices suggest that the refi boom and the market rally--assuming it holds up--will boost spending in coming months.

Also, recent data do not suggest that consumers are overextended, even after record sales of homes and cars. At the annual conference of the Global Interdependence Center on Nov. 4 in Philadelphia, Bruce Kasman, chief U.S. economist at J.P. Morgan Chase & Co., noted that consumer spending on durable goods and housing as a share of GDP was 13% in the third quarter. That's close to the long-term average of 12.7% and well below the nearly 15% share hit after the recessions in the 1970s and 1980s.

BUT THE MOST IMPORTANT SUPPORT to future consumer spending will be income growth. Real aftertax income advanced at an annual rate of about 3% in the second and third quarters, even with no job growth. And in October, average hourly pay of production workers was up 0.2% from September. Companies are able to grant wage increases that are still running ahead of inflation because they have continued to increase the productivity of their workforce.

The downside of those efficiency gains is that businesses are expanding output without adding people. Indeed, in the first three quarters of this recovery, productivity gains have accounted for twice as much of the advance in economic growth compared with the average experience in the previous nine recoveries.

Nevertheless, while job markets are stagnant, they are not getting worse. Payrolls posted tiny declines in both September and October, but they are higher now than six months ago. Since April, manufacturers have shed nearly 200,000 jobs, but payrolls of private-sector service companies have grown by almost 300,000. And although the October jobless rate edged up to 5.7%, from 5.6%, unemployment claims through October headed downward. If the jobless rate holds steady in November, consumers may grow more confident about the economy's future.

THE BUSINESS SECTOR, however, is where uncertainty about the future has caused the most trouble, and manufacturers have felt the hardest blow. Factory output began falling in August and probably declined again in October, based on the dip in the Institute for Supply Management's index of industrial activity to 48.5%, from 49.5% in September. A reading below 50%, means the sector is contracting.

But even in manufacturing, there are signs of future improvement. The ISM's index of new orders popped above the 50% level for the second month in a row. Also, businesses continued to buy more equipment. Outlays for items such as computers, turbines, and forklifts rose at an annual rate of 6.5% in the third quarter. Spending on information-processing gear alone increased 13%, the third consecutive advance (chart).

Business sales and profits are gradually starting to pick up. Third-quarter overall demand in the economy, adjusted for inflation, rose 2.4% from a year ago, the best annual showing in nearly two years. And that occurred at a time when rising productivity and falling unit labor costs allowed companies to earn more on each unit of product they sell. As a result, when the Commerce Dept. reports its accounting of third-quarter corporate profits on Nov. 26, look for a strong gain that will provide the funds necessary to finance further equipment outlays and hiring.

That good news may not resonate much if investors are focused on forecasts of dismal fourth-quarter GDP growth. But what's important to keep in mind is that the fundamentals--plus some extra insurance from the Fed--argue that the economy will strengthen over the next few months, and it will head into 2003 with more momentum than it has right now.

By James C. Cooper & Kathleen Madigan

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