The Upswing: Reasons for Caution
The performance of the U.S. economy during this year’s second quarter raises some questions concerning the sustainability of the business expansion.
To be sure, even though the growth rate of the real gross national product, at 2.6%, was only slightly more than half of the first quarter’s pace, it was better balanced. Real sales to consumers increased at a 3.3% annual rate, compared with a decline of 2.3% in the first quarter.
This means that inventory-building was not the only reason the economy grew, in contrast with the first quarter, when all of the increase in output, and then some, stemmed from swelling stockpiles.
Furthermore, there was continued improvement in our foreign trade position. Although the United States in the second quarter ran another large deficit in its balance of trade, the red ink diminished for the third quarter in a row. This means that more of what people are buying is being made here--an obvious boost for domestic output.
However, when one looks beneath the surface of these statistics--not to mention other factors--one finds plenty of reasons for caution. First of all, the contribution to growth made by the shrinking trade deficit narrowed in the second quarter. As measured in gross national product accounts, our trade deficit, adjusted for inflation, shrank only $7.4 billion in the second quarter--little more than half the average decline of the two previous quarters.
How much longer the trade deficit can decline is open to question. For one thing, the dollar has strengthened against the major currencies since May. Unless reversed, this will limit any further improvement in our competitive position.
But consider also, that, against the currencies of a group of countries with whom we do more than half of our trade--including Canada, our largest trading partner--the dollar has fallen little, if at all. This means that our manufacturers still are losing ground.
Growing Inventories a Concern
Against this background, the fact that inventories grew almost as fast in the second quarter as they did in the first has to be worrisome. If U.S. businessmen are unable to convince consumers to buy more of their products in the coming months--instead of those produced overseas--inventories once more will pile up and output will have to be cut.
As it is, consumer spending will be limited by the rise in inflation and the increases in interest rates this year. The consumer price index in the first six months of 1987 rose 5.5%, nearly twice the rate of average hourly earnings. And most interest rates are one to two percentage points higher today than they were last spring.
The prognosis for inflation is not good. This year, the rate of consumer price inflation, on an annualized basis, is five times last year’s rate, and the highest for any six-month period in almost five years.
Further increases are in store. At the producer or wholesale level, price increases in intermediate materials excluding food and energy have been accelerating. After declining at an annual rate of 1.5% in 1986’s second quarter, these goods--including such items as containers used to ship manufactured goods--rose 0.8% in last year’s third quarter, 1.5% in the fourth, 2.7% in 1987’s first quarter and 3.5% in the second.
Inflation pressures are even more apparent at the earliest stage of production. Prices of such industrial raw materials as copper, scrap steel and lead--considered to be very sensitive to changes in supply and demand--have shot up nearly 25% over the past year.
Needless to say, prices of imported goods are up sharply, reflecting the earlier decline of the dollar in foreign exchange markets. And the cost of oil today is more than double its low point of April, 1986.
With this trend on the inflation front, it is not surprising that long-term interest rates recently have returned to their highs of earlier this year. Bond market participants are always sensitive to prospects for inflation, since they have great bearing on the buying power of their principal.
As a consequence, mortgage rates are up to more than 11%, from less than 9 1/2% in late winter. This has cut into the ability of people to afford a house--sending new-home construction down for four months in a row.
Interest Rates Up Across the Board
Interest rates are up across the board, thanks to a firming of Federal Reserve monetary policy. As outgoing Fed Chairman Paul A. Volcker stated in Congressional testimony last month, the Fed tightened the money supply in May in response to growing fears of inflation and to spring’s plunge in the dollar in foreign exchange markets. What’s more, the Fed hasn’t relaxed its credit hold since then, in contrast to market thinking.
I don’t expect an easing of Fed policy anytime soon. Inflation is still on the rise and the dollar needs supporting. Additionally, the monetary growth targets for 1988 have been trimmed.
This does not mean there are no circumstances under which interest rates could fall. Here are several that come to mind:
- A sudden weakening of the economy. Quite clearly, an early recession would result in lower rates, since the demand for funds would decline, while the Fed probably would ease.
- A marked strengthening of the dollar. This would reduce the need for the Fed to support the dollar--but it would also lead to less economic growth.
- A financial crisis. The banking system, already reeling from bad loans, could receive another blow if debt problems worsen with developing country, corporate, consumer, oil, farm or real estate customers.
- On the positive side, a federal budget agreement that gets the U.S. budget deficit under control would move rates lower by cutting Washington’s need for funds and easing investors’ fears of inflation. However, this is not judged to be very likely--at least as long as the current administration is in office.
Putting it all together, while it is fairly likely that the business expansion--now in its 57th month--will live to celebrate its fifth birthday later this year, I would not bet a great deal that there will be a sixth birthday party for this upswing come November, 1988.
