March 28, 2001

When the Federal Reserve lowered interest rate targets early in January, the poor Christmas season and the collapse of consumer confidence was uppermost in their minds and policy guidance documents. The unexpected rebound in consumer confidence last month has sharply diminished fears that the consumer will stop spending in the next few months.

Instead, the problems seem to be mounting for corporations. They still believe technology is a good value that can significantly create efficiencies. Most corporations still plan to spend large increases on capital. However, their dwindling confidence has stopped the execution of those spending plans.

A year ago, shipments of durable goods were growing at double digit rates before adjustment for deflation. Orders were growing in the teens as everyone sought gains from the new technologies. Any weakness in orders was caused by the inability to timely ship the requested goods.

Last week, the February durable goods report painted a remarkably different picture. Shipments are off more than 4 percent from the previous year. Orders are down more than 7 percent. Even after a 6 percent rebound in orders of electronics and electrical equipment from January to February, orders in that sector are down 6.8 percent from the previous year.

The only orders bright spot from the previous year is in industrial machinery, which eked out a 1.1 percent gain. Those orders, however, fell 2.4 percent in February.

At a minimum, there no longer is any momentum in capital spending. More likely, most of those capital spending plans will not be fulfilled this year.

Not only do these spending plans threaten economic growth, but they also may lead to lowered gains in productivity.

Economists continue to speculate over why productivity rebounded so strongly in the past half dozen years following two decades of minimal gains. Clearly, some especially useful technology contributed to the strong improvement in recent years. However, some studies suggest that as much as 1.3 percentage points of the 2.8 percent annual gains in productivity during the past six years is the result of additional capital for existing workers.

If capital spending continues to slow, as it did so abruptly in the fourth quarter, those favorable productivity gains will diminish. We could have reduced efficiency and slowing economic growth at the same time. Either profits will plunge or price increases will intensify or a bit of both will surface.

The latest CPI report shows that core inflation in the past year already has increased to 2.7 percent. Moreover, price gains outside of food and energy rose an even more robust 3.1 percent in the past three months. In short, inflation is beginning to drift upward.

As the year began, stock market analysts were hoping that corporate profits would increase slightly from previous year levels. Today, they are expecting that profits will plunge more than 10 percent below year ago levels in the winter and remain below the previous year until the fall.

In other words, profits are plunging, especially in technology. There, profit declines of almost 40 percent are now expected for the first quarter and profit growth may not resume until early next year.

If these profits expectations deteriorate even more rapidly, then stock prices will fall further. Only if these declines already are priced in the equities markets can stock prices rise while profits fall. So far, the stock market continues to hammer prices of companies announcing further profit reductions. That means profits continue to surprise analysts with their weakness.

Needless to say, those strong productivity gains that support the surpluses Bush is using to justify his tax reductions will not materialize if corporations continue to drag their feet in making capital spending decisions.

We now know that consumer confidence is a smaller problem than initially feared. Unfortunately, we are just beginning to realize that the lost confidence is in corporate board rooms. Reduced confidence there may create even more serious economic problems than a reluctant consumer.

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