The final puzzle piece has slipped into place. Since early February, news covering the drawdown in inventories, buoyant consumer spending, and resilient housing has supported the idea that the recovery is here. Now, the latest data suggest that the factory sector is joining in the rebound.
This bounce is significant for two reasons. First, manufacturing was in a downward spiral well before the overall economy: Back in late 2000, factories were reporting sagging orders, production cuts, and huge layoffs. Second, although manufacturing represents just 16% of the economy, it is much more volatile than private services or government. Thus, for a sustained recovery to be in place, the economy needs manufacturing to at least hold steady.
The recent news has been uniformly upbeat for the entire economy. Consumer spending began the first quarter well above its fourth-quarter average, car sales are holding up, and the nation's purchasers said industrial production and orders are rising (chart).
The Federal Reserve also reported a more stable economy in its Mar. 6 Beige Book, the roundup of regional economic activity. The book, which was prepared in advance of the Mar. 19 policy meeting, said "a majority of Federal Reserve districts report some signs of improvement in economic conditions in January and early February." Economists expect the Fed to keep the federal funds rate at its current 1.75%. Moreover, there is almost no expectation that the Fed will begin to lift rates before the second half.
The latest numbers suggest that the old saw about mild recessions begetting mild recoveries may no longer hold true in an economy shaped by technological advances, compressed reaction times, flexible labor forces, and spreading globalization. If so, 2002 could be a stronger year for the economy as a whole--and for manufacturers in particular.
PROBABLY THE BEST NEWS on the industrial outlook came from the nation's purchasing managers. The Institute for Supply Management said its purchasing managers' index jumped from 49.9% in January to 54.7% in February. For the first time since July, 2000, the index was above 50%, the dividing line between a factory recession and expansion. Meanwhile, the PMI for nonmanufacturing--mostly services--rose sharply in February, to its highest level in 15 months.
For the ISM's manufacturing report, the readings for new orders and production were particularly striking. February's orders index was the highest in more than seven years, and the 9.2-point jump in the production index was the largest since 1983, when the U.S. was climbing out of the brutal 1981-1982 recession. The ISM said that an index reading of 54.7%, if sustained for all of 2002, would correspond to a 4.4% increase in real gross domestic product for the year.
The purchasing managers are getting increasingly worried about the sparse level in inventories held by their customers. In February, 25% thought the inventories were too low, a result of the steep liquidation in 2001. In the fourth quarter alone, businesses cut their stock levels at an annual rate of $120 billion. Despite that, the Commerce Dept.'s revisions showed that the economy grew at a solid 1.4% annual pace last quarter, up from the original 0.2% rate. The upward revision came from higher consumer spending and fewer imports.
Factories pared inventories again in January, but not as drastically as at the end of 2001. Factory stock levels fell an additional 0.6%, the smallest drop since May. The slowdown suggests businesses may no longer see a need to keep shrinking their inventories (chart).
THE END OF INVENTORY-CUTTING will be a big plus for manufacturers in 2002. Last year, U.S. goods producers did not benefit from the lift in consumer spending because businesses satisfied that demand from existing stock levels. Even though people were still buying, industrial production fell sharply last year.
Now, wholesalers and retailers have much less inventory on hand. That means they will have to reorder goods, which will lead to increased production. In the auto sector, it's already happening. Detroit used incentives to ensure that consumers would keep buying vehicles after September 11. Record car sales cleared out inventories in the fourth quarter. Auto makers cut back on incentives in early 2002, but car sales held up surprisingly well in the new year. In February, sales of cars and light trucks sold at an annual rate of 16.7 million, up from 15.8 million in January (chart). In response, the major auto makers are expanding their production schedules and adding overtime to some plants. Increased vehicle production probably caused industrial production to rise in February for the first time in seven months.
THE RISE IN VEHICLE PURCHASES suggests another advance in consumer spending in February. In January, real consumer purchases increased by 0.3% from December. That means real spending started the first quarter at a healthy 1.4% above its average of the fourth quarter, when demand surged 6%, thanks mostly to record car sales. For the rest of 2002, households seem willing and able to keep their outlays growing at a pace that will keep manufacturers busy.
Note that even though consumer purchases of durable goods began the quarter falling at a 19.1% annual rate from the fourth quarter (reflecting the drop-off in car sales), outlays for nondurables such as food, fuel, and clothing started the quarter 8.7% higher. Spending on services--about half of total purchases--began at a 2.7% pace. Services are on a track to post the best quarterly showing in more than a year.
In addition, the outlook for capital spending, especially for tech equipment, may be improving faster than was expected a few months ago. Factory orders rose 1.6% in January, helped by a jump in high-tech bookings. Excluding aircraft, nondefense capital goods increased 1.5%, the third advance in the past four months. Given that only 72.7% of factory capacity is being used now, an upturn in capital spending might seem unusual. But businesses will invest in equipment during this coming year not as a way to add capacity but to increase the efficiency of their facilities.
Of course, risks still exist in the outlook. One danger is that fears of a too-strong rebound will keep long-term rates rising. However, until a sustained recovery is well established, the Fed is unlikely to begin to nudge short-term interest rates back up.
Cooler heads will keep in mind that the outlook is all a matter of degrees. The U.S. economy is not headed back to the overheated surge of the late 1990s; it is recovering from its 2001 recession. And for the first time in about 18 months, all the economic data--including those from manufacturing--look a lot better. By James C. Cooper & Kathleen Madigan