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U.S.: A Mild Recession, a Wimpy Recovery


Disappointed with the recovery? Don't gripe about ineffectual policymakers in Washington or the liars in Corporate America or the stock market bust. Blame the mild recession.

That may sound perverse, given that a mild recession is preferable to a severe one. But the recovery of 2002 is proving that the economy's new resilience comes at a cost. True, structural change, better productivity growth, and preemptive policy have worked to smooth out the business cycle. However, because last year's recession was one of the shallowest on record, it created little in the way of pent-up demand to propel the recovery, as had been true in past upturns.

For example, housing and vehicle sales did extremely well in 2001, and overall consumer spending never declined--the first time that has happened in a recession. But now consumer demand is not showing the typical recovery burst, which fuels output growth and new jobs.

As a result, this recovery isn't as strong as many executives, job seekers, and investors had hoped for, even though growth in real gross domestic product has averaged nearly 3% during the past three quarters. And without the usual recovery surge to lift spirits and embolden companies to spend and hire, a moderate recovery raises risks for the next few quarters, since it makes the economy more vulnerable to shocks, such as the stock market's drag, geopolitical events, or rising oil prices (chart). Little wonder, then, that the economy seems to be hesitating instead of roaring ahead.

CONSIDER THE LATEST MIXED DATA: Consumers are still spending in the third quarter, especially for autos. Housing is holding up, thanks to low mortgage rates, although potential for further gains is limited. Most recently, manufacturing has hit a dry patch, and the trade deficit continues to subtract from economic growth. On the financial side, fewer commercial banks are tightening their lending standards, but the terms of loan agreements are somewhat stricter.

These diverse trends in the economy are why investors are contemplating another interest-rate cut by the Federal Reserve. Those expectations rose after late-July news that real GDP grew at only a 1.1% annual rate in the second quarter, raising questions about the recovery's sustainability. So far, subsequent data haven't justified worries about a faltering economy.

The Fed, however, is taking no chances. On Aug. 13, policymakers officially shifted their view, saying that the balance of risks in the outlook has swung toward possible economic weakness. That means the upcoming data--including the August employment report and purchasing managers' index--will sway the decision on whether to keep rates on hold or to lower them at the Fed's Sept. 24 meeting.

HOWEVER, ONE REASON not to fear a second-half economic swoon comes from the Fed itself. Its August survey of banks' senior loan officers says business loans are increasingly available. The report shows, on net, only 21% of the 56 banks surveyed tightened their lending standards for commercial and industrial (C&I) loans to large and midsize companies, down from 25% in April and 45% in January. For loans to small companies, only 5% tightened up on standards, down from 15% in April and 42% in January (chart). For the first time in a long while, a bank or two actually eased standards.

While this pattern argues against a credit crunch, banks are more stringent on the terms of their loans. In August, more banks increased the spread between loan rates and their cost of funds, mainly citing economic uncertainty. Still, that survey percentage is below what it was at the end of 2001. Lending practices to households were little changed and remain generally accommodative.

The Fed survey also shows business loan demand remained weak. However, that reflects the modest recovery, not a credit crunch. C&I loans are typically used to finance inventories and other short-term business operations. And now that companies have slowly begun to restock their shelves, loan demand may also pick up gradually. Business inventories rose 0.2% in both May and June, the first increases in more than a year. Inventory rebuilding is concentrated at retailers and wholesale distributors, while the rate of liquidation in manufacturing has eased considerably since 2001.

The inventory readjustment helped boost factory output in the first half. But recent data raise questions about manufacturing's strength in coming months. Industrial output in July rose just 0.2%, and excluding autos, production was down 0.1%. Factory output is no greater than it was a year ago.

In addition, the Fed revised the second-quarter output data. The new numbers show output of computers and office equipment grew at an annual rate of 4.9% last quarter, a far cry from the 20.4% clip originally reported. That means the tech rebound is weaker than first thought (chart), and the sector may not add much to real GDP growth going forward.

The disappointing output numbers followed reports of a drop in the July purchasing managers' index and a plunge in capital-goods orders in June. Plus, a Philadelphia Fed survey indicated that region's factory activity contracted in early August. Why the slowdown? Executives might be hesitant to go forward with spending plans until the issues of corporate governance are settled. The good news is that, given the stock market's better performance in recent weeks, corporate scandals may be less of a drag on the economy.

CONSUMERS, MEANWHILE, are spending, but the cumulative burden from the stock market, job jitters, and higher oil prices may finally be taking a toll. Thanks to a 1.2% jump in July retail sales, real consumer spending is on track to grow at a solid 3.5% annual rate in the third quarter. And surveys indicate vehicle sales for August are holding up. But other retail buying is sluggish at a time when families are preparing for the new school year. Back-to-school buying has become a good leading indicator for the important yearend holiday shopping season, so the final August sales data may say a lot about fourth-quarter demand.

Higher fuel prices may be one reason for the cautious spending. Mideast instability and a possible U.S. attack on Iraq have pushed crude-oil prices up 50% so far this year, to nearly $30 per barrel. On the positive side, though, jobless claims continue to fall. That's an indicator that the labor markets are stabilizing and better job growth will support consumer spending going forward.

Nonetheless, the trends in oil prices and jobless claims point up the clashing forces now hitting the recovery. The economy is like a boat navigating choppy waters: It still appears the ship has enough ballast to stay afloat, but unlike many past recoveries, the coming voyage may not be a smooth one. By James C. Cooper & Kathleen Madigan


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