U.S.: The Funk on the Factory Floor

Exports are off--and low-cost imports make it tough to raise prices

The Commerce Dept.'s Feb. 20 report showing another sharp widening in the foreign trade deficit caused some forecasters to revise their estimates of the fourth-quarter drag from trade on the U.S. economy. But more important than any rearview-mirror effect is trade's impact on the future, especially for the struggling manufacturing sector. Export and import trends will have big roles in determining levels of economic activity and inflation in 2003.

The jump in the trade gap in December to a record $44.2 billion, from November's $40 billion, resulted from a 2.6% drop in exports and a 1.7% increase in imports. The numbers caught most analysts by surprise, but the data represented a continuation of patterns evident throughout 2002: With domestic demand growing at a solid pace, imports kept gaining U.S. market share all year. At the same time, other economies around the world struggled, so they had little need or desire to buy more American-made goods. Consequently, U.S. exports fell (table).

Trade's impact on the U.S. economy will be twofold. First, until overseas demand picks up, a complete and lasting recovery in U.S. manufacturing will remain elusive. Second, the rise in imports from low-cost producers, most notably China, means manufacturers will have a difficult time raising prices. The chief beneficiary will be U.S. consumers, who will continue to find bargains at shopping malls. The biggest losers will be manufacturers' profits, their workforces, and investors.

ALTHOUGH ITS SHARE of payrolls has declined for decades, manufacturing remains a bellwether for swings in the business cycle. It was industrial excesses--too much inventory and too much capacity--that triggered the 2001 recession. Manufacturing companies also play a major role in the stock market. (It's not called the Dow Jones industrial average for nothing.)

That's why the current weakness in U.S. manufacturing is worrisome. The latest downbeat readings on regional industrial activity from the Federal Reserve Banks of New York and Philadelphia show that goods production, which increased in January, slowed in February.

Moreover, February's stunning 15-point plunge in consumer confidence was caused in large part by job jitters that can be traced to manufacturing's troubles: The Conference Board said its index of consumer confidence dropped from 78.8 in January, to 64 in February, the lowest reading since 1993 (chart).

The board said war worries, oil prices, and a lack of jobs pushed the index lower. In February, 30.1% of consumers thought jobs were "hard to get," up from 28.9% in January. That pessimism reflects the 2.2 million private-sector jobs lost since the recession began in March, 2001. Three-quarters of those jobs, 1.7 million, have been at factories, even though manufacturing accounts for just 15% of private payrolls.

A factory rebound depends greatly on improvement in the demand for exports, which account for about 20% of the output of goods in the U.S. Most important of all, U.S. manufacturers need Europe's economies to show more muscle in 2003. Although the U.S. shipped fewer goods to almost all other countries in 2002, the drop-off to Western Europe was especially steep. Exports across the Atlantic fell by $17.6 billion. That was half of the total decline in exports, even though Europe accounts for only 22% of U.S. foreign sales. Exports to Germany, the largest of the euro zone economies and the one in the most trouble, shrank by 11% last year.

Recent hints by European Central Bank President Wim Duisenberg of a possible cut in interest rates would help the euro zone's prospects. But any loosening of monetary policy probably won't come soon enough to help the U.S. factory sector in 2003.

IN THE MEANTIME, American manufacturers are also grappling with the import surge. In the fourth quarter of 2002, imports accounted for 26.7% of all nonoil goods bought in the U.S. That's up from 20.4% 10 years ago. Expect that market share to edge up further in 2003, given America's ever-increasing appetite for German cars, Korean electronics, and Chilean wines.

In recent years, however, no country has made greater inroads into the U.S. market than China, which saw its shipments to the U.S. jump by 22% last year, which was equal to the total increase in imports. As a result, China surpassed Japan last year as the No. 3 exporter of goods into the U.S., behind both Canada and Mexico.

China now accounts for 11% of U.S. imports, up from 1.5% 15 years ago. China also accounted for about 1.5% of exports back then, but because of the strong dollar and severe import restrictions in China, the share of U.S. shipments bound for China increased to only 3% last year (chart). That growing divide in trade flows is why the U.S. deficit with China has more than doubled in just five years.

CHINA IS ONE OF MANY low-cost producers that will have an impact on not only the outlook for U.S. manufacturers, but also on the prospects for inflation. Because of the stronger dollar, import prices for nonoil goods fell 11% from mid-1995 to early 2002. Since then, the dollar has weakened, and most import prices have stabilized. But not all of them. Of the five product categories where China accounts for at least 20% of U.S. imports, four show falling prices over the past year.

Clearly, U.S. manufacturers cannot compete with Chinese producers when it comes to labor costs. Cheaper labor will enable China to keep the costs of its exports down and boost its market share in the U.S. Right now, China's dominance is in lower-end items, but as the country's manufacturing skills improve, it will start making more technologically advanced products, suggesting that China's pressure on the pricing power of U.S. producers will only grow.

The import trend is a key reason why the inflation outlook, especially for goods, remains so benign in the U.S. In January, consumer prices rose 0.3%, or 2.6% over the past year, but costlier energy is distorting the trend. Yearly core inflation, which excludes food and energy, stood at 1.9%, down from 2.6% in January, 2002.

However, that overall rate reflects a huge import-related split in inflation rates for goods and services. Core inflation for services in January was 3.4%, while the rate for goods was -1.4%. Foreign competition is also holding down prices of U.S.-made products: Excluding energy and food, wholesale prices for finished goods, those made by U.S. producers, are up a mere 0.5% over the past year.

Intense competition from imports and continued strong productivity gains will be the foundations of continued low inflation this year and next. So, in the months ahead, U.S. factories will need stronger demand from both home and abroad to get back on their feet. And this recovery cannot kick into a higher gear until the industrial sector gets moving again.

By James C. Cooper & Kathleen Madigan

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