BARRON'S: Economic Beat -- Pacing The U.S. Economy

It's Dynamic Enough To Foil More Recession

By Ian Shepherdson

These past few weeks have been a gratifying time for the double-dip

fraternity. Surveys of both business and consumer confidence -- key leading

economic indicators -- show a marked softening in the wake of the drop in stock

prices. Although the confidence-survey results remain consistent with positive

growth in output and spending in the medium term, the abrupt declines in the

latest readings might indicate an immediate disturbance in the recovery.

I still expect the economy to grow at a reasonable clip in the third quarter

and beyond. But with the pace of growth having slowed substantially in the

second quarter, only a fool would argue that there is no possibility of a

decline in gross domestic product. This would be the first in a year and,

without a doubt, bad news. But it's not clear that it would presage the start of

a second leg of recession, or that the Fed should respond by cutting interest

rates again. Not every dip marks the start of a recession, but there are solid

grounds for believing a GDP decline now would represent one of these rare

instances.

The U.S. business cycle is a ponderous beast, not given to sudden movements

unless subject to extraordinary forces. The drop in stocks has pulled powerfully

on the reins, but must be seen in the context of the forces pulling in the other

direction.

First, as Federal Reserve officials never tire of saying, the current stance

of monetary policy is very accommodative. The real fed-funds rate -- nominal

rates less the rate of increase of the core personal consumption deflator --

stands at just 0.1%, compared with its 20-year average of 3.3%. The money supply

is expanding very rapidly indeed, and it's hard to argue that near-8%

year-over-year growth in M2 is anything but positive for growth. Bank lending

remains very subdued, but that is normal at this stage in the cycle. A key

reason for the softness in lending is that companies have unloaded huge piles of

unwanted inventory built up in the boom's final stages. Inventories are now very

low in relation to sales across most of the economy.

Inventory shedding turbocharges a downswing, ensuring that overall GDP falls

faster than spending on consumption and investment -- final demand, in other

words. If there is no excess inventory to shed, this cannot happen: Companies

cannot get rid of what they don't have, and the extent of the downturn is

limited by what happens to final demand.

A determined double-dipper would no doubt argue that final demand could fold:

Spooked corporations could keep capital spending on hold until the uncertainty

diminishes, and consumers might try to rebuild their shattered savings. But

capital spending has already been dramatically reduced and may have reached

something like an irreducible minimum. Most companies can't delay replacing old

or obsolete equipment indefinitely just because the near-term economic outlook

is unclear. When you're buying a business asset for use over the next few years,

what matters is the medium-term prognosis, which surely remains favorable.

Meanwhile, consumers are awash with cash, despite the very soft labor market.

Wages are growing only modestly, but total real disposable personal income --

the key measure of consumers' spending power -- has risen a very substantial 5%

over the past year. About half of this has come from tax cuts.

Income growth at this pace is sufficient to support both a robust increase in

spending and a rise in the saving rate, which has already hit its highest level

in more than three years. Note, too, that the income numbers don't take account

of the latest huge wave of mortgage refinancing, which is putting billions into

consumers' pockets every week. Low mortgage rates are also sustaining the

extraordinarily strong housing market.

Also, real government spending rose by more than 4% in the year to the second

quarter. Spending is unlikely to continue climbing quite so rapidly, partly

because states and municipalities have finally realized that they're running out

of money, but the public sector will keep contributing to growth.

From the Fed's perspective, this all adds up to a long list of reasons to

believe that a dip in economic activity needn't translate into a new recession.

It follows that treating the dip with a dose of lower interest rates is

pointless. The Fed would probably find that a further easing simply makes an

inflation problem more likely next year or in 2004, while doing nothing for

growth in this year's second half.

It would be more sensible for the central bank to wait to see how the economy

shapes up, while making clear that rates will be cut if a new recession seems to

be emerging or if further weakness in the markets threatens the financial

system.

Some recessions last much longer than others. But we can't think of any that

have started against a backdrop of very loose monetary and fiscal policy,

extraordinarily low inventories, hugely compressed capital spending and a

slightly weaker dollar. While the next round might go to the double dippers,

remember that a knockdown isn't necessarily a knockout.

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IAN SHEPHERDSON is the chief U.S. economist for High Frequency Economics.

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