In his first public remarks on the economy since October, Federal Reserve Board Chairman Alan Greenspan sounded decidedly cautious when he discussed recovery prospects on Jan. 11. In particular, he emphasized his concern that "we continue to face significant risks in the near term," suggesting that he might favor another quarter-point cut in interest rates--if only as recovery insurance--at the Fed's Jan. 29-30 policy meeting.
His somber tone was somewhat surprising to those investors who were beginning to think this easing cycle was over and that the Fed's next move would be a rate hike later this year. After all, the recent data seemed to bolster optimism about a recovery. Consumer confidence has picked up, and spending is surprisingly strong. Businesses are clearing out inventories at a record pace (chart). Factory activity is improving. Even the tech sector is shaking off some of its weakness.
However, Greenspan seems to understand something that investors are overlooking: Two recoveries are under way right now. One is the sharp bounceback from the September 11 terrorist attacks, the other a more gradual rebound from the demand slowdown and inventory overhang that began a year ago.
The problem is that much of the upbeat data in recent weeks reflect the V-shaped response to the September shock. Focusing on the upswing of that V may exaggerate the strength of the coming upturn. Investors who look at the unexpectedly good data and then bet on a robust recovery and strong profit turnaround may find themselves disappointed by midyear. A return of bearish sentiment on Wall Street could create a huge drag on demand in the second half just as other stimulative factors, such as inventory rebuilding, are trying to boost growth.
GREENSPAN ALLUDED to the two-recovery idea when he said that economies around the world, including the U.S., seemed to be going through "a coincident deceleration in activity" over the past year owing partly to the "retrenchment in the high-technology sector." There were hints that the slowdown was stabilizing before September, he said, but the attacks breached "the fabric of business and consumer confidence." After the shock, "U.S. economic activity did drop dramatically."
To a great extent, that drop-off was linked directly to the attacks. For instance, a quarter of the 819,000 positions lost in October and November were in travel-related industries such as airlines, hotels, restaurants, and amusement parks, which account for 6% of all jobs. New orders plunged when executives, uncertain about the future, held off on making decisions. Consumers stopped shopping for a few weeks.
Now, the shock effect is dissipating, making the economic numbers look very good compared with their summer levels. But the firmer data may cause a misreading of the economy's underlying health.
THE BIGGEST DISTORTION may well be the dramatic drawdown of inventories combined with the increase in consumer spending in the fourth quarter. Bear in mind that companies were dealing with an inventory overhang well before the terrorist attacks. Through the first nine months of 2001, businesses had reduced their stock levels at the fastest three-quarter pace in the postwar era.
Then came September 11 and the consumer shutdown. Detroit responded by offering lucrative incentives. Record vehicle sales cleared out car dealers' lots. In November, business inventories fell 1%, after a 1.6% plunge in October. Both drops were concentrated in retail auto inventories. The steep inventory drawdown last quarter subtracted heavily from growth in real gross domestic product, perhaps more than two percentage points. Some forecasters expect that inventory liquidation for the fourth quarter alone nearly equaled the pace for 2001's first three quarters combined. Greenspan called the liquidation "extraordinary," a strong word for a man who tends to speak in generalities.
The key point is that consumer spending, mainly on autos, offset perhaps all of that drag. The Commerce Dept. won't release the GDP data until Jan. 30, but the numbers on retail sales and car buying through December suggest that real household spending grew in the neighborhood of a 4% annual rate last quarter (chart). That's a strong pace in any quarter and an amazing result in the middle of a recession.
However, the incentives stole vehicle purchases from the first quarter. Car sales this quarter are surely dropping, and that will cause an outright decline in total consumer spending. For the rest of 2002, household demand is likely to proceed more slowly than the fourth-quarter pace, given rising unemployment and little additional room for growth in both autos and housing, the sectors that have always driven past rebounds in consumer spending.
At the same time, inventories will provide a lift to the economy. Businesses might not be ready to beef up their warehouses, but in the GDP math, a slower pace of inventory liquidation actually adds to real GDP growth. That boost will begin in the first quarter.
IN ANOTHER ALLUSION to the two-recovery notion, Greenspan noted that inventories and consumer spending "will have important consequences for the economic outlook in coming months." But looking further out, he said, "the broad contours of the present cycle have been, and will continue to be, driven by the evolution of corporate profits and capital investment."
Those segments of the economy were in trouble prior to September 11, and they face the toughest road. Although companies froze their capital-spending decisions right after the terrorist attacks, the problems facing equipment makers--overcapacity, bloated inventories, and excessive demand expectations--started to build in late 2000. Adjustments to these excesses will take considerable time to work through, and until capital spending stops falling, the U.S. economy cannot mount a healthy recovery.
Equipment manufacturers, especially in the tech sector, showed some improvement in the fourth quarter. Output of tech equipment edged up a bit, the first gain in a year. More important, tech manufacturers increased capacity by 12.9% from a year ago, the smallest addition in eight years (chart).
Total industrial production fell at a 7.2% annual rate last quarter, but the small 0.1% dip in December suggests that factory activity was stabilizing at yearend. While that is encouraging, it will take the January numbers to show whether that plateau reflects mostly the V response to September 11 or if manufacturing, and thus the overall economy, is truly getting back on its feet.
On that point, Greenspan sounded wary. "Despite a number of encouraging signs of stabilization," he said, "it is still premature to conclude the forces restraining economic activity here and abroad have abated enough to allow a steady recovery to take hold." By James C. Cooper & Kathleen Madigan