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INVENTORIES ARE CASTING A VOTE OF NO CONFIDENCE
At this stage of the business cycle, the recovery process should be moving along without a hitch. Consumers should be gathering goods off store shelves and thus prompting retailers to rebuild inventories. Manufacturers should be busy making the goods to restock warehouses, providing needed increases to production and payrolls.
But in these dog days of summer, the recovery mechanism has hit a snag: the reluctance of businesses to rebuild inventories. Consumers are buying, but only at a modest pace. And businesses seem so unsure of the recovery's strength that they are hesitant to restock their shelves (chart). Consequently, factory orders are sluggish and industrial production has stalled.
The absence of strong inventory rebuilding, along with hardly any growth in consumer spending, is a big reason why the second quarter's gross domestic product grew below the 2.7% annual rate of increase posted in the first period. It is also why the recovery in industrial output hasn't been as robust as in past upturns.
The lack of another type of stockpiling partly explains the stagnation in the labor markets: Service industries aren't building up their payrolls. The inventory of service producers is not services. It is the workers who provide those services. And as long as this sector, which employs more than three-fourths of all workers, continues to slim down and cut costs, job growth will not provide a strong push to consumers' income and spending.
The recovery process is still in gear--it's just stuck in low gear. Further modest growth in GDP seems assured in the third quarter. Consumer buying begins the current quarter at a high level compared to the second quarter. Also, auto production will keep factory output moving ahead, and lower interest rates will help housing.
But the kick from inventory rebuilding that typically gives recoveries a big boost is missing. First-quarter liquidation of inventories turned out to be far less than first measured. That, plus slow restocking in the second quarter, implies that the swing in inventory growth supplied only a moderately positive lift to last quarter's GDP growth. Meanwhile, sluggish consumer spending suggests that overall demand barely grew.
Inventories rose a scant 0.1% in May, and adjusted for prices, real inventories have fallen in four of the last five months. Retailers actually cut their stockpiles in May by 0.3%. That caution undoubtedly reflects the recent sluggishness in retail buying.
All this fell back on goods producers in June. Industrial production in manufacturing, mining, and utilities dropped 0.3% in the month, reflecting sizable cutbacks in auto assemblies and output of construction supplies (chart). And the industrial operating rate dipped from 78.9% to 78.5%. Both drops were the first since January.
Despite the June weakness, however, industrial production should continue along a rising trend. Output rose at an annual rate of 4.5% last quarter after falling 2.9% in the first. In the third quarter, Detroit is beefing up its production schedules, and construction should perk up in a lagged response to lower mortgage rates.
The disappointingly slow pace of recovery must be weighing heavily on the mind of Federal Reserve Board Chairman Alan Greenspan as he prepares for his semiannual testimony on monetary policy on July 21 and 22. Greenspan will have to forecast the outlook for the economy and give the central bank's preliminary target ranges for money growth for 1993.
His biggest task: explain why money growth has fallen through the lower end of its current targets. Greenspan must also address the risks to the recovery of below-target money growth. And he will have to reconcile the apparent inconsistency between the current pace of M2 and the Fed's forecast for economic growth.
It will not be easy. A large cut in the federal funds rate in December, 1991, has done little to accelerate the growth of the Fed's favorite measure of money, M2. In fact, M2 has fallen some $35 billion since it peaked in early March. That slide included a large $7.3 billion drop in the last week of June, which placed M2 some $34 billion beneath the low end of its target range of 2.5% to 6.5% annual growth for 1992.
Given the combination of weak money growth and a sluggish economy, further Fed action cannot be ruled out--particularly since inflation is becoming less and less of an issue. Price pressures just are not a problem for this moribund economy. In June, consumer prices rose just 0.3%, while producer prices of finished goods advanced by only 0.2%.
Excluding food and energy, the core rates of inflation are even less of a threat to the economy. Core producer prices fell 0.1% in June and are up only 2.5% from a year ago. And consumer prices, excluding food and energy, rose by just 0.2% last month, for a yearly gain of 3.8%.
The airfare wars in early June brightened the inflation performance for the month. The average cost of air travel plunged 6.5%, while the prices of apparel, tobacco products, and toiletries declined as well.
But it isn't just inflation in goods that is trending lower. The pressures on service prices are also receding. Led by a slowdown in housing costs, the annual core rate of inflation in services stands at only 4.1%. That's down considerably from 5.4% during the previous year (chart).
For now, there is little reason to believe that price pressures will reignite anytime soon. Wage gains will remain extremely modest in the face of lackluster labor markets. And weak demand means businesses are unlikely to risk losing customers by raising prices.
The lethargic pace of spending, however, is why businesses are so wary about making commitments in the areas of inventories and jobs. That's especially true for companies catering to consumers--whose spending accounts for two-thirds of the economy. After sharply cutting their spending in March, consumers have headed back to stores. But the pace of spending is very modest.
In June, retail sales moved up by 0.5%. Coming on top of gains in April and May, retail sales have recouped all of the steep 1.2% decline in March (chart). Because of that loss, store receipts started off the second quarter at a big disadvantage. And after adjusting for inflation, retail volume was down slightly last quarter.
The high level of buying in June, though, means that retail sales should post a gain in the third quarter, compared with the second. New U.S.-made cars sold at a 6.5 million annual rate in early July. That's down from June's pace of 6.8 million, but still respectable.
Another good sign for future shopping is the sharp drop in mortgage rates, which should rouse the soft housing recovery. Increased home sales will help spur buying of furniture, appliances, and building materials--retail categories that stumbled in the second quarter.
In addition, consumers who missed out on refinancing their mortgages in January may now take advantage of the latest drop in rates. With the average rate of a 30-year fixed mortgage now at 8.21%, homeowners who refinance will see their monthly payments drop significantly.
In addition, retail sales in June may have taken an indirect hit from the airlines' price war. Consumers shelled out about $2 billion for cheap tickets in early June, leaving less money for retailers. And since airfares are included in outlays for services, the airline skirmish suggests that the June report on overall consumer spending, due out on July 31, could look very healthy.
Some better economic news would provide cool relief to the central bank, which watched as the recovery hit a snag in the spring. The recent disappointing signs don't add up to a triple dip. But until the recovery gets some pickup in jobs or the money supply, this economy faces anything but clear sailing in the second half.JAMES C. COOPER AND KATHLEEN MADIGAN