BUSINESSWEEK ONLINE : JULY 31, 2000 ISSUE
BUSINESS OUTLOOK U.S.: One Quarter Does Not a Soft Landing Make So far, there's little evidence the slowdown will last into the second half With apologies to Shakespeare, the past is not always prologue. Although the economy slowed considerably in the second quarter, it is not clear that the spending hiatus is continuing into the second half. And unless it does, the U.S. economy remains at risk for a rise in inflation and higher interest rates. The Commerce Dept. will report its first look at second-quarter real gross domestic product on July 28. Armed with the recent data on softer consumer spending, economists surveyed by Standard & Poor's MMS, like BUSINESS WEEK a unit of The McGraw-Hill Companies, expect that real GDP grew at an annual rate between 3.1% and 4.2%, with a median forecast of 3.8%. That's well below the 5.5% annual rate of the first quarter and the 7.3% surge in the fourth quarter. The available monthly data on retail sales, housing, and job growth underlie the expectations of a second-quarter slowdown. Those numbers suggest that domestic demand may have grown by about 4% last quarter, down from its torrid 7.8% pace of the first quarter. And another record trade deficit in May means the foreign sector subtracted from growth again (chart). So far, though, the data on incomes, confidence, and orders show no reason to expect that demand will stay subdued long enough to allow some slack to creep back into the economy. Keep in mind that growth anywhere north of 3.5% is probably higher than this economy can maintain without increasing production capacity and further straining already tight labor markets. Upward pressure on these key supply factors--labor and physical capital--will determine the inflation outlook. Already, core inflation is edging up. If demand snaps back, cost pressures, especially in the wage arena, could push inflation even higher. TWO KEY UNKNOWNS for second-quarter GDP are inventories and foreign trade. That's because Commerce must make estimates for the June data for both. These sectors, while small in absolute terms, can swing widely and greatly affect the top-line GDP number. In fact, inventories played a big role in the ''spring break'' phenomenon of the past two years. In 1998 and 1999, GDP growth in the second quarter slowed sharply from the first quarter, only to pick up quickly in the third. Both times, a drawdown in inventories contributed heavily to the temporary pause. In 2000, though, the monthly data on inventories suggest that stockpiling of goods added to growth last quarter. Inventories held at manufacturers, wholesalers, and retailers jumped 0.5% in April and 0.8% in May. Inventories were up 6.1% from 12 months ago, the fastest yearly pace in 4 1/2 years (chart). Whether that accumulation was intentional or not will affect future output. If producers did not expect domestic demand to slow as quickly as it did, then businesses began the second half overloaded with merchandise and supplies. Factory orders will soon slow, and manufacturers will scale back their production plans. On the other hand, if producers are restocking in anticipation of a demand rebound, then producers should stay busy in the second half. U.S. producers can also count on more business from overseas. Although exports fell 1% in May, the outlook for stronger global growth means that export growth should improve in the second half. Even so, rapid import growth means that foreign trade may remain a drag on the U.S. economy. Since imports in May fell just 0.3%--less than exports--the month's trade gap rose from $30.5 billion in April to $31 billion. FOREIGN DEMAND is already contributing to the pickup in industrial activity. Industrial output increased 0.5% in May and 0.2% in June. Manufacturers alone lifted production 0.4% and 0.3%, respectively. Overall industrial output grew at a 7% annual rate in the second quarter, the largest gain in four years. As a result, industry is using more of its capacity. Operating rates averaged 82.1% in June, up from 80.5% a year ago. While the rate is still below the 83% or so mark associated with production bottlenecks and supply shortages, it has been climbing steadily, despite the Federal Reserve's best efforts to slow the economy. The Fed's brake-tapping has succeeded in cooling off housing. Residential construction probably did not add anything to second-quarter GDP growth, and it may even have cut into it. Higher mortgage rates are keeping some potential buyers out of the market. That means homebuilding could exert a small drag on the economy in the second half. The consumer sector also cooled down this spring. Retail sales fell 0.5% in April, rose just 0.3% in May, then climbed 0.5% in June. When adjusted for price changes, including the spike in gasoline prices, real retail buying managed to increase at an annual rate of just 1% last quarter. That means that total real consumer spending on goods and services grew only about 3% in the second quarter, compared with increases that averaged a hot 6.2% in the previous three. THE KEY QUESTION, of course, is whether consumers will keep a tight rein on their spending. On that account, the second-quarter data are not so Fed-friendly. Consumers still are very upbeat about job prospects, wage gains are accelerating, and the recent rebound in the stock markets may keep overall consumer confidence at a high level. The one factor working in the Fed's favor is the continued drag on household budgets from gas prices. Energy prices jumped 5.6% in June alone. And recent reports indicate that people will be paying more to heat their homes when the weather turns cold. Sticker shock at both the gas pump and the thermostat could suppress consumer spending much more than the Fed's six interest-rate hikes have so far. Higher fuel prices continue to lift inflation. Consumer prices for all goods and services jumped 0.6% in June. Core prices, which exclude food and energy, increased a more modest 0.2%. Core inflation, however, is picking up. Over the past year, those prices have risen 2.4%, a bit faster than their 2.1% gain in June, 1999. The acceleration has been all in services. Annual core-service inflation in June stood at 3.2%, up from 2.7% a year earlier. Goods inflation is still running at just 0.6%, but that sunny news may not last long. Goods inflation in the U.S. has been kept low in part by falling import prices, a result of the strong dollar and the recessions abroad. Import prices are no longer dropping, however. In fact, prices for core imported goods rose 1.3% over the past year-- twice the advance in overall core-goods prices (chart). The only surefire antidote to a rising inflation rate this year is a slowdown in economic activity. One quarter, though, won't cut it. Only a longer-running slowdown will ease the production strains and price pressures that are beginning to build in this economy. By JAMES C. COOPER & KATHLEEN MADIGAN _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ BACK TO TOP					RELATED ITEMS U.S.: One Quarter Does Not a Soft Landing Make CHART: Foreign Trade Remains a Drag on Growth CHART: Inventories Grow at a Rapid Clip CHART: Core Import Prices Are Creeping Higher INTERACT E-Mail to Business Week Online

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