U.S.: The Economy Is Showing Real Muscle

Inventory building and overseas demand have joined consumer spending

Economists have been busy lifting their forecasts for real growth in gross domestic product in the first quarter. The advance number will be released by the Commerce Dept. on Apr. 29, and the range of forecasts veer from a modest 3.7% to a booming 6%. The monthly data available so far suggest that the economy probably grew at a 5% annual rate or better. But what is more critical than the rate is where the economy's strengths lie and what the mix says about future momentum and risks.

Indeed, no sooner had the economy and labor markets started performing better than fears over inflation clouded the outlook and rattled the financial markets. The question among investors is when and by how much the Federal Reserve will lift short-term interest rates now that the economy shows so much muscle. Even the International Monetary Fund has emphasized that the Fed must be clear about its intentions or it risks disrupting financial markets around the world.

However, investors who argue that the Fed is behind the curve or did not anticipate the economy's current strength ignore the fact that policymakers have been forecasting strong real GDP growth for some time. The Fed's central tendency forecast shows that in February policymakers projected real GDP to grow by 4 1/2% to 5% for all of 2004. So growth as high as 6% last quarter would not be far outside the Fed's range of expectations.

For his part, Alan Greenspan sounded upbeat -- and straightforward -- when he testified before Congress on Apr. 20 and 21. The Fed chairman's speeches were his first attempts at communicating what lies ahead for monetary policy. After saying the economy's prospects were good and that hiring will pick up, he downplayed growing inflation fears. He noted that strong productivity has limited the growth in labor costs, and that high profit margins and competition mean companies won't automatically boost their prices to cover rising costs.

And in a bow to transparency, Greenspan said quite clearly that "the federal funds rate must rise at some point to prevent pressures on price inflation from eventually emerging." That was a very clear signal the Fed is on the path to lifting the funds rate from its current 1%. The next confirming sign may come in the policy statement released after the Fed's May 4 meeting.

THE TIMING OF THE FIRST RATE HIKE will be mostly based on the outlook for growth and jobs. And in that regard, the details of the Apr. 29 GDP report should make the case that the economy had quite a lot of momentum heading into the second quarter. In fact, any shortfall between reported GDP growth and expectations will most likely be made up over the spring and summer.

Companies Are Finally Adding to Inventory
That's especially true for the inventory sector. From the recession until mid-2003, businesses were extremely hesitant to build up their stockpiles. Inventories dropped in seven of those 10 quarters. The reluctance can be traced to two factors. First, companies doubted the increases in demand had staying power, and they didn't want to get caught with excess inventories. Second, the cost of supplies were either falling or stable, giving companies a financial incentive to delay ordering goods.

Now demand has proven itself resilient, and commodity prices are rising. No wonder attitudes about inventories have turned 180 degrees. In January, 2001, a survey by the Institute for Supply Management found 26% of purchasers thought their customers' inventories were too high, and 14% felt they were too low. But this March, the too-high responses had fallen to 8%, and the too-lows were up to 29%.

INVENTORIES BEGAN RISING at the end of 2003, adding 0.7 percentage point to fourth-quarter real GDP growth of 4.1%. So far in 2004, total inventories held by manufacturers, wholesalers, and retailers were up 0.2% in January and another 0.7% in February, the largest one-month addition in 3 1/2 years (chart). Although March data on total inventories aren't yet available and Commerce must estimate them for the GDP accounts, the numbers so far suggest inventory building could have added at least one point to GDP growth.

Better still, inventories are still playing catch-up with the growth in demand. The ratio of business inventories to sales stands at historically low levels. Companies must add significantly to their inventory levels through the spring and summer or risk losing sales. That stockpiling will provide a big boost to future economic expansion.

Inventory rebuilding is also pumping up the factory sector. Although manufacturing output was flat in March, that followed a surge of 1.1% in February and a smaller gain of 0.3% in January. For the first quarter, factory output increased at a robust 5.8%. And given that the backlog of unfilled orders is the highest in two years, output will post further advances in the spring.

THE TWIN REBOUNDS in inventories and factory output are in response to continued gains in demand. The monthly data on car sales and other retail buying show consumers remain the driving force in the economy. Real consumer purchases grew between 4% and 4 1/2% last quarter. And households have little reason to pull back on their spending this spring because the labor markets are picking back up, many tax refunds have yet to arrive, and household wealth is rising. The extra cash from refund checks and the boost to incomes from more jobs will offset the drag from higher fuel prices.

Businesses are also helping to push up demand. The monthly data on shipments of capital goods suggest that business investment on equipment rose in the first quarter. Although the increase probably was not as hefty as the 14.9% gain posted in the fourth quarter, it may have been big enough to add half a percentage point to real GDP growth. And a recent survey done by the National Association for Business Economics indicates capital budget plans will remain robust for the rest of the year. According to the NABE, 53% of their members expect capital spending at their companies will rise in the coming year; 14% expect the gains to be 10% or more.

Export Growth Is Gaining Momentum
Perhaps the most welcome addition to demand for U.S. goods is coming from overseas. Real exports rose strongly in both quarters of the second half, and another advance should be posted for the first quarter, according to the monthly data (chart). Foreign demand is critical to keeping America's massive foreign trade deficit at least stable. In fact, the reason the February trade gap narrowed to $42.1 billion from $43.5 billion is that a 4% increase in exports more than offset a 1.6% rise in imports.

Gains in U.S. exports are also a good indicator that growth is accelerating worldwide. Economic expansion must be widespread and resilient around the world so financial and product markets adjust easily to an expected slowdown in China's economy.

As usual, the U.S. will help to set the pace for stronger world growth. Resilient consumer spending, faster inventory rebuilding, and better export growth all contributed to first-quarter growth. And that mix will provide the momentum needed to power the economy into the second half.

By James C. Cooper & Kathleen Madigan

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