May 3, 2001

Following the surprisingly strong report on Gross Domestic Product during the winter, some economists have assumed that a recession no longer is likely. They may be right. However, the economy still suffers from several problems that suggest that such a hasty conclusion is not yet justified.

The good news is that the excess inventories that led to such strong declines in manufacturing activity are rapidly being reduced. Some further production reductions may be needed in the spring to get inventories to desired levels. Then production will need to rise back to the level of sales.

Also, the dramatic plunge in profits during the fall do not appear to have been replicated in the winter. Some prices increased, as the price deflator for GDP rose 3.2 percent. This is about 1.5 percentage points above winter price gains. Productivity appears to have slowed, but only about half a percentage point. Energy prices continued to rise, but slightly slower in the winter than in the fall.

Thus, prices improved relative to costs by more than a percentage point as compared to the fall. This still is not enough to generate profit gains, but the loss in profits certainly is much less than half the $85 billion decline in domestic nonfinancial profits during the fall.

But there is bad news as well.

The rise in prices provided some relief from rising cost pressures, but it also continued to drain the purchasing power of consumers. Indeed, some of the large growth in credit card balances during the winter may have been caused by rising utility bills that forced some households to pay only minimum balances on their credit card debt.

This exhaustion of consumer purchasing power could undermine spending later in the year. The drop in auto sales in April to an annualized rate of 16.7 million from 17.3 million the month before suggests that consumer spending will be much less vigorous during the spring than in the winter.

If consumer confidence continues to erode and paychecks shrink as layoffs intensify, then minimal gains in consumer spending may surface. Rarely does a recession occur solely because of consumer spending retrenchment. However, weakening spending could coincide with other problems to generate a recession.

Furthermore, the rising rate of inflation is beginning to undermine the confidence of long term bond investors. Fixed rate mortgages have increased half a percentage point in the past forty-five days. This could begin to undermine the one strong area in the economy--construction.

However, adjustable rate mortgages are continuing to fall. Many first time homebuyers use adjustable rates to qualify for their home mortgage. Thus, the more expensive houses may begin to suffer but the starter homes may remain strong.

Non-residential construction also could be undermined by weaker consumer spending and layoffs. Some real estate analysts suggest that the change in Cisco's prospects have altered office demand in California by the equivalent of twenty five office buildings. A similar story can be told for many other companies in many other places, including Atlanta.

Even with the rebound to 2 percent growth, the economy is now growing half as fast as the gains in industrial capacity. Do we need so much fixed investment when so much is being under-utilized?

Probably the largest concern is in trade. The trade balances improved during the winter, adding almost 1.7 of the 2 percentage point growth in activity. However, the gains were because of falling purchases of capital goods from abroad, declining consumer goods purchased abroad, and declining purchases of international industrial materials.

If these purchases fell because U.S. producers were more competitive, that would be good. However, they declined because the U.S. economy was too weak to absorb international production. The result is a slowing world economy that could continue to restrain growth here.

My own guess is that economic activity will grow very slowly during the spring--probably less than 1 percent, and then gradually improve during the second half of the year. This means no recession, but this outcome remains far from certain.

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