Business Outlook: A Second-Half Recovery Could Be Fleeting

The worst recession since the 1930s is drawing to a close. The sharp contraction in the economy appears to have moderated notably in the second quarter, and a return to growth in the third quarter is now widely expected. Unfortunately, it won't feel much like a recovery, because growth in the second half likely will be too puny to generate enough jobs to make a dent in the unemployment rate. There is also a more important issue: Will the upturn last?

The question arises because the early stage of the recovery is going to be production-led, not demand-led. Businesses have slashed output so far below the level of overall spending that some increased production will be needed just to slow the overly rapid depletion of inventories. That boost to output will be necessary even without much growth in demand. And there's the rub. To keep the production rebound—and the recovery—going into 2010, overall spending will have to pick up, and that's the big uncertainty given the headwinds facing consumers.

These trends will be key features of Washington's report on second-quarter real gross domestic product on July 31, which will also include major revisions to previous years. Economists expect real GDP to have declined last quarter between 1% and 2%, after plunging 5.5% in the first quarter and 6.3% in the fourth. Business inventories appear to have been liquidated possibly at a record rate, even as spending by consumers and businesses fell. Through the first quarter, stockpiles already had posted the largest four-quarter drop on record.

In past recessions, inventory liquidation and the subsequent rebuilding of stocks have always played a big role in the ups and downs in real GDP growth. The inventory cycle almost certainly hit its nadir in the second quarter, and it is now ready to boost growth, not subtract from it. Manufacturing output is set to turn up this quarter after six consecutive quarters of decline. A firming in factory activity will have a stabilizing effect on the broader economy: So far this year manufacturing has accounted for 30% of job losses and 50% of the drop in income from wages and salaries.

The inventory-related rebound will be led by auto output, as General Motors (GM) and Chrysler gear up. Their shutdowns and cutbacks led to a record drop in cars on dealer lots. Over the past year sales of U.S.-made vehicles have fallen 28%, but production has plunged 55%. The "cash for clunkers" program also will help spur output.

The inventory story goes beyond autos. In May and June the percentage of companies surveyed by the Institute for Supply Management who said their customers' inventories were "too low" stood at 31% and 28%, respectively, the highest levels in five years. Even minimal growth in overall demand should be sufficient to keep real GDP rising modestly through yearend.

Most forecasters expect the economy to grow at an annual rate of about 2% in the second half, but most of the gain will come from the waning need to slash inventories. The problem is that, without a pickup in consumer spending, any inventory-led bounce in growth will stall. Note that since the 1970s consumers contributed, on average, 3.5 percentage points to the growth in real GDP in the first four quarters following a recession. This time, that's most likely impossible.

Enormous government support to household incomes in the first half of 2009 is set to fade even as labor markets remain weak. So far this year wages and salaries, which make up nearly 60% of aftertax income, have fallen at a 3.1% annual rate, but total aftertax earnings still have grown at a 10.8% pace, reflecting tax cuts and a host of federal programs. But with these plans now fully implemented, their impact on income growth is fading as wages and salaries keep falling.

Because of this recession's record inventory liquidation, the potential need for restocking—and the impetus to boost economic growth—is substantial. But any recovery will be fragile until the labor markets can offer U.S. households a sustainable source of income growth.

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