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Now, It's Services vs. Recession


With manufacturing and construction on the ropes, service industries are helping to rally the U.S. economy, but the going's getting tougher

As the U.S. economy tries to fight off a recession, has it found a way to avoid a knockout? So far, strength in many service industries is delivering a powerful counterpunch to hits from homebuilding, autos, and other goods-producing businesses. Despite the economy's tepid 0.6% growth rate last quarter, its service sector advanced a sturdy 3.5%. Consumer spending on goods plunged 2.6%, but outlays for housing, medical care, and other services rose 3.4%. Heading into the second quarter, while overall April payrolls shrunk by 20,000 jobs, services added 90,000. And in contrast to the weakness in manufacturing, the Institute for Supply Management says April service-sector activity continued to grow.

There's no denying the sector's increasing impact on economic trends. Services make up almost 60% of gross domestic product, up from 55% a decade ago and 52% the decade before that. However, despite that growing influence, the more important engines of the business cycle have always been the goods-producing sector and construction, and they are taking an unusually heavy pounding.

Dropping Demand for Goods

This sharp divergence reflects the unique set of forces affecting the economy, especially consumers. The mix of tighter credit, the double hit to buying power from fewer jobs and higher prices for energy and food, and shrinking household wealth are killing demand for big-ticket consumer goods such as homes, cars, and other discretionary purchases.

As a result the downturn in the goods-producing sector is intensifying. Despite strong exports, manufacturing output is down two quarters in a row, and in April, hours worked posted the largest drop in five years, pointing to a steep fall in industrial production. Automakers are getting hit especially hard as April vehicle sales dropped to a 14.4 million annual rate, the lowest since 1998, led by flagging demand for gas-guzzling sport-utility vehicles.

The pressure on autos and other credit-sensitive goods is only getting worse as the credit crunch spreads. The Fed's April survey of banks' senior loan officers showed sharply tighter lending standards, up from the already elevated January readings. For large companies, the percentage of banks clamping down was the highest since the 2001 recession. A rising percentage also tightened up on mortgage lending to households, even for prime mortgages. Meanwhile, standards for credit cards and other consumer loans rose significantly, partly reflecting higher required credit scores.

Dwindling Incomes

Even as credit is drying up, jobs and incomes are shrinking. Since payrolls peaked in December, service employment through April is up 98,000, but goods-producing jobs have plunged 358,000. Overall, more people are having trouble finding full-time work. This year's rise in the number of people forced to work part-time is the fastest since the 2001 recession. Total hours worked began the second quarter well below their first-quarter level, and with hourly pay slowing, income growth, almost all of which has been eaten up by inflation over the past year, began the quarter on a weak note.

So far, despite consumers' weaker incomes, their savings rate remains close to the near-zero level of the past two years, implying they are spending about the same proportion of their earnings. That means factors other than income have not yet had a negative impact on spending, but that trend will be put to the test this quarter.

As household wealth, which had helped to make up for low savings, falls, along with credit availability and consumer confidence, consumers may soon be forced to save more of their incomes. There's a good chance the tax rebates will be either squirreled away or used to pay down credit cards. A shift to greater saving would tend to hit outlays for both goods and services.

On balance, recession forces appear to be getting stronger this quarter, not weaker. That will put even more pressure on the goods sector. And while the service sector's resilience may help to keep the recession mild, it won't necessarily be able to prevent one.

Cooper is BusinessWeek's senior editor and senior economist and writes the influential Business Outlook column.

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