U.S.: A Surprise Pickup—With Room To Run

Consumer spending and cheaper oil are fueling a bonanza few saw coming

Is the slowdown over? It's starting to look that way. Last quarter the economy appears to have outperformed the expectations most forecasters held only a few weeks ago. In early December, a BusinessWeek survey showed that, on average, economists believed growth in the fourth quarter would post another tepid showing to match the third quarter's 2% advance. Now, given the surprising strength in a number of yearend reports, including retail sales, industrial production, jobs, and foreign trade, many analysts think the economy is regaining some momentum that will carry into 2007. Further declines in energy prices in January will only add to the forward thrust.

The first official word on the economy's overall performance in the fourth quarter will come on Jan. 31, when the Bureau of Economic Analysis reports its first estimate of the quarter's growth in real gross domestic product. Many economists now believe real GDP grew in the not-too-shabby neighborhood of 3% last quarter, and, more important, the mix of pluses and minuses among the GDP'S various components will point to continued healthy growth in the first quarter as well.

All this runs counter to fears that last year's progressive slowing in growth—from 5.6% in the first quarter to 2.6% in the second quarter and 2% in the third—was a precursor to an extended period of weakness, or even recession, fueled by the slump in housing and a buildup of excess inventories across a broad array of goods. The fourth-quarter GDP report will offer the strongest evidence yet that the housing downturn is an isolated event and that any inventory problem capable of depressing growth in early 2007 is well on its way to being eliminated.

PERHAPS THE MOST IMPORTANT trend to note in the upcoming GDP data is the diverging patterns of housing and consumer spending. In the second half of 2006, as residential investment was falling at an increasingly rapid rate, consumer spending was actually accelerating.

Based on monthly reports through November, residential investment in the fourth quarter appears to have declined at an even greater rate than the third quarter's 18.6% plunge, which followed an 11.1% drop in the second quarter. Last quarter's drop will most likely subtract more than a percentage point from overall GDP growth, which would be the biggest quarterly drag due to this component since the 1981-82 recession.

Yet at the same time, the data on retail sales imply consumer spending grew in the range of 4% to 4.5%, a sharp advance on the third quarter's 2.8% increase, which was a shade faster than the second quarter's rise. Consumers contributed close to three percentage points to gdp growth last quarter, the kind of boost seen in a boom, not a slowdown. So much for the notion that the housing decline is dragging consumers down.

Consumers will still have plenty of wind in their sails heading into the first quarter. Solid back-to-back gains in retail sales in November and December—0.6% and 0.9%, respectively—show a rising trajectory, especially when the ups and downs caused by gas prices are excluded. December's record mild weather helped, and temperatures in the first half of January may spark a similar boost, especially as a record volume of gift-card redemptions hits the sales numbers.

Consumers Showed Momentum At Yearend
But the strength is more fundamental than that. Outside weak spots in housing and manufacturing, payrolls in the other 80% of the private sector grew faster in the second half of 2006 than in the first half, and overall incomes grew strongly.

Buying power also got a big boost in the fourth quarter as the price of crude oil fell from the summer's $70-per-barrel range to around $60 per barrel in the fall. Now, a further decline to just above $50 is unfolding, which will add more oomph to first-quarter spending.

THE GDP REPORT WILL SHOW that considerably slower growth in business inventories was the other major depressant on fourth-quarter economic growth, but the drag will not extend into the first quarter. Stockpiles of goods had grown by $53.7 billion and $55.4 billion in the second and third quarters, respectively, even as demand was slowing. The two-quarter jump was the largest in two years. The unwanted buildup, which was concentrated in motor vehicles and housing-related materials, added to fears that a long period of production cutbacks and layoffs would be needed before businesses could pare inventories back down to size.

Those fears are proving to be unwarranted. The problem was not that big to begin with, based on the inflation-adjusted ratio of business inventories to sales, which measures the adequacy of inventory levels. Through October, the ratio had risen only slightly above its trend since 2000. This trend has been declining, as new techniques reduce the amount of inventories businesses need to hold. Still, the above-trend increases in 2001 and 2003—which resulted in sharp output cuts—were much greater than the recent rise.

The inventory pullback appears to have subtracted up to a full percentage point from fourth-quarter GDP growth. The slowdown suggests aggressive cutbacks in production and imports through November, along with steady strength in overall demand, have largely eliminated the overhang. So to the extent this stock-level adjustment has already run its course, the stage is set for a rebound in production in the first half of 2007. Indeed, December factory output posted a big 0.7% advance from November, the first monthly gain since August.

IT SEEMS THAT FOR EVERY BIG MINUS in the GDP components last quarter, including inventories and housing, there were counterbalancing pluses to spare. In addition to the big lift from consumer spending, real gdp growth received a sizable boost from foreign trade. That trend might well continue in 2007, though maybe not as positively as in the fourth quarter of 2006.

Not Much Of An Inventory Problem
Thanks to a surprise narrowing in the trade deficit in both October and November, the shrinkage appears to have added about a percentage point to fourth-quarter growth. The monthly gap narrowed to $58.2 billion in November, the smallest since July, 2005, as exports jumped and imports slowed.

The slowdown in imports reflected a temporary lull in demand for petroleum products and for materials related to the softness in housing and autos. Still, the trade deficit should be less of a drag on growth this year because of booming exports. Overseas demand is strong, especially for capital goods, and the lower dollar is more competitive.

Add in a solid gain from business investment in equipment and construction, along with another increase in government outlays, and it's easy to see why economists are lifting their expectations for last quarter's growth into the 3% range. More importantly, the upswing appears to have legs. As the drag from the housing and inventories sectors begins to lift in the first half of 2007, the economy seems more likely to speed up than slow down.

By James C. Cooper

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