U.S.: Consumers Are on Hold, but They Haven't Hung Up

Demand should recover in the second half -- if there are no new shocks

They say April is the cruelest month. Not so for the U.S. economy this year, and that's particularly true for households, whose spending has been the glue holding this ragtag recovery together. In February, a Code Orange terror alert, spiking gasoline and heating oil prices, heightened war worries, and a blizzard that swept through the Midwest and Northeast were enough to cause even the most optimistic households and businesses to hunker down and wait for better days.

As a result, the economy, which had shown progress in December and January toward breaking out of its soft patch, appears to have slipped back into the mire. With consumers and businesses facing a new round of pessimism, first-quarter economic growth may not rebound much from its paltry 1.4% pace in the fourth quarter. Moreover, the drags from war, energy prices, and uncertainty over jobs and profits may spill over into second-quarter growth as well.

However, hunkering down is not the same as throwing in the towel. After two years of cutbacks in outlays and hiring that have brought enormous productivity gains, businesses are extremely lean. There is no evidence that they're gearing up for a new round of cuts. Instead, they are on hold, waiting to see how global politics play out in their markets. The same is true for consumers. Outside of higher energy prices, which will cut into household spending, the fundamentals underlying consumer demand are no worse now than they have been over the past year, a period in which spending rose by nearly 3%.

All this means that, barring any shocks, the first half will not be prologue for the second half. Consumer demand will bounce back, especially if the war effort in Iraq is quick and successful. And with the veil of uncertainty lifted, businesses will be in a position to respond very quickly to improving demand.

BUT THAT COMES LATER. Right now, business activity in both manufacturing and nonmanufacturing, while still expanding in February, did so at a slower pace than in January (chart). And housing was clearly a casualty of the first quarter's frigid weather. January sales of new homes fell 15.1%, the largest monthly plunge in nine years, and the blizzard probably caused home sales and construction to founder in February.

More important, consumer spending appears to have declined in both January and February, while March is still up for grabs. Real consumer spending in January fell 0.3%, mainly reflecting the sharp drop-off in auto sales to an annual rate of 16.1 million from December's incentive-boosted rate of 18.2 million.

Then in February, the weather and homeland security dealt a double-blow to spending. Car-buying fell further, to a 15.4-million pace, the lowest in four months. And additional sales of duct tape and plastic in the wake of the terror alert were no help to retailers in the Northeast, as the blizzard whited out nearly all of their business during the heavily promoted President's Day weekend. Consumer buying in March, the month in which any war with Iraq will probably begin, will most likely be depressed as well.

CONSUMERS MAY BE DOWN, but they are not out. Why? To begin with, oil prices are generally believed to be at least $10 higher than the global forces of supply and demand would normally dictate, meaning that households will benefit from cheaper energy after the Iraq crisis.

Second, while the labor markets are soft, payrolls excluding manufacturing, which make up 85% of private-sector jobs, are up from a year ago. And despite the slower growth pace of workers' hourly earnings, aftertax incomes are rising at a healthy 3% clip from a year ago, thanks to tax relief (chart).

Last, low interest rates are allowing households to replace high-cost installment debt with cheaper, tax-advantaged mortgage debt. Federal Reserve Chairman Alan Greenspan noted in a Mar. 4 speech that consumers took nearly $200 billion of equity out of their homes through mortgage refinancing in 2002. Of those cash-outs, about $70 billion went to repay home-equity loans, and "a significant part was employed to reduce higher-cost credit-card debt." Indeed, the yearly growth rate of revolving debt, mostly credit cards, had fallen to only 1.6% at the end of 2002, a two-decade low, after peaking at more than 12% in early 2001 (chart).

At the same time, Greenspan noted, low rates kept the debt-service cost of mortgage debt last year little changed from that in 2001. And despite the huge amount of equity that households extracted from their homes last year, rising home prices, up 7% last year, meant the amount of untapped home equity ended the year higher than it was at the start of 2002.

All this means that homeowners still have the ability to use home-equity loans to finance increases in spending, although not to the huge extent they did last year, even as they enjoy further gains in their housing wealth. That gain in net worth, coupled with the rise in take-home pay, suggests the consumer sector, in general, remains in solid financial shape.

CORPORATE AMERICA'S FORTUNES may not be as favorable as those for consumers, but some business trends have turned positive. January's 2.1% gain in capital-goods orders was the second increase in a row, and excluding aircraft, capital-goods demand was up 5.4%. Demand for capital equipment has been remarkably stable over the past year. That suggests some companies are going ahead with capital-spending plans even amid war or corporate governance worries.

Production schedules are also holding up. The Institute for Supply Management (ISM) reported that its manufacturing activity index slipped to 50.5% in February, but any reading above 50% indicates that industry is expanding. The production index dipped to 55.4%, from 56.3% in January, and the ISM noted that any reading above 49.9% is generally consistent with a rise in the Fed's industrial production data.

The ISM data also showed orders were rising, although at a slower pace than in January. In particular, export orders remain on an uptrend, which would signal a nice reversal of the decline in exports in 2002.

Production should increase further once demand picks up because inventories are at such lean levels. Business' stockpiles are low when compared to current sales gains. That means companies are not carrying enough merchandise on hand to satisfy any bump up in demand, which could happen suddenly if the Iraq confrontation is resolved quickly.

Of course, the when-and-how of the Iraq showdown remains the 800-pound gorilla in the outlook. Geopolitical uncertainties helped to quash the momentum evident at the start of 2003. By now, the economy should have been revving up to a higher gear, with business spending and hiring picking up. Instead, the first quarter is playing out as the winter of our discontent.

By James C. Cooper & Kathleen Madigan

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