HISTORICAL ECONOMIC COMMENTARY

Week of January 29th, 2009

Washington took center stage in the financial arena this week, as president Obama delivered the State of the Union message, a divided Senate confirmed Fed chairman Bernanke for a second term, an embattled Treasury Secretary was hauled up to a hostile Capitol Hill to testify about the AIG bailout and the Federal Reserve held its regularly scheduled policy-setting meeting. Despite the headline-grabbing dominance of each of these events, none provided major surprises. Stock prices swooned, as much in response to the increasing negativity that seems to be emanating from Washington than to any new fundamental development. Profits are generally meeting, if not beating, expectations, and the economy remains firmly on a recovery track, although a good deal of uncertainty about how it will perform as government stimulus wanes this year persists. Still, investors ended the week and month on a downbeat note, sending stock prices lower.

Stocks did briefly recover on Friday morning following a solid fourth-quarter GDP report and signs that consumer confidence is firming up. As was the case with the array of Washington episodes, there were few surprises in the GDP report, but the markets may have been encouraged by the absence of negative revelations. Reassurance can be a comforting influence amid a sea of uncertainty, which has clearly buffeted investor psychology in recent weeks. Yes, the headline data came in somewhat stronger than expected. Real GDP spurted by an annual rate of 5.7 percent, well above the consensus forecast on Wall Street of a 4 - 4 ½ percent increase. However, that outsized gain, the steepest in more than six years, greatly exaggerates the fundamental strength of the U.S. economy.

Keep in mind that the first estimate of GDP, which this is, contains many assumptions about how key sectors performed in December, including trade and inventories. Not coincidentally, both of these components contributed significantly to the fourth-quarter growth rate. Most important, and least surprising, was the inventory contribution, which accounted for an eye-opening 3.4 percentage points of the 5.7 percent gain in GDP. As we have been commenting for some time, the Great Recession had a cataclysmic impact on business psychology, prompting companies to shut down production and meet sales solely out of inventories, resulting in a record seven consecutive quarters of inventory drawdowns. But massive liquidations of stocks can go on for only so long before companies are so lean with merchandise they must step up production or lose sales.

That turnaround is now underway, as a reduced fraction of sales is being met out of inventories and more out of increased production. True, the real volume of stocks is still declining, falling at an estimated $33.5 billion annual rate in the fourth quarter. It is important to remember, however, that while the change in inventories has a direct impact on the level of GDP, it is the rate of change that influences the growth rate of GDP. Hence, the $33.5 billion inventory reduction in the fourth quarter was considerably less than the $139.2 billion drawdown in the previous three-month period. That $105.7 billion difference represents a slowing in the rate of change that contributed a whopping 3.4 percentage points to the economy's growth rate in the fourth quarter.

The problem with a recovery that is powered so importantly by inventory changes is that it is vulnerable to a setback if final demand doesn't hold up. Then companies would revert to its old habit of meeting sales out of stocks and refusing to book new orders, which is essential to sustaining the revival in production. Fortunately, that flashpoint does not appear imminent. Real final sales of domestic product, defined as GDP less inventory changes, increased at a 2.2 percent pace in the fourth quarter, which is up from 1.5 percent in the third quarter and the strongest in two years. To be sure, the growth rate in final demand is far from robust - it is still below the long-run average of 2.7 percent - but the fact that it is accelerating is an encouraging sign. It's also a far cry from a year ago, when final sales were collapsing at a 4.7 percent rate.

It is also important to recognize that an inventory-induced spike in growth does not occur in a vacuum with no consequential knock-on effects. When an increasing fraction of sales is met through higher production instead of out of inventories, more labor input is needed. That, in turn, provides an income boost, which fuels more spending. Simply put, inventory swings can jump start a recovery and set in motion self-reinforcing influences that generate momentum, builds confidence and opens the door to a long-lasting expansion. Whether the stage is set for a repeat of that cyclical dynamic is still open to question, however. The nation is not emerging from a garden-variety recession that requires little more than an inventory spark to sustain it. Not only are formidable headwinds still suppressing the positive impulses that would ordinarily propel the recovery forward. The stimulus from government programs is set to fade in coming quarters, and there remains the very real question of whether the recovery can survive without these props.

Housing is one sector that has received an enormous amount of government support, and the jury is still out regarding its future. Recent data have not been encouraging, as sales of both new and existing homes took a sharp turn for the worse in December. The plunge was expected, since sales were pulled forward to November due to expectations that the first version of the $8000 homebuyer tax credit would expire at the end of the month. The credit has since been extended through April, which should have a positive influence on sales over the next few months. But tighter mortgage-lending standards and a high level of job insecurity are major impediments that should keep a lid on sales transactions.

If there is one positive element to the housing picture it is the much-improved balance between demand and supply in the new-home market that is giving a boost to construction. With builders adding the fewest number of new homes to the market in the postwar period, inventories of unsold units fell dramatically last year. In December, only 231 thousand newly built homes were up for sale, the smallest number since March 1971. And, thanks to the sales spurt launched by the homebuyer tax credit during the spring and summer months, outlays on residential construction turned up in the third and fourth quarters of last year, following 14 consecutive quarters of decline. The fourth-quarter increase was modest and only contributed a slim .14 of a percentage point to the economy's overall growth rate. But that's a marked improvement over the 1 percentage point drag associated with the collapse in residential building in 2008 and 2009.

Chances are, housing activity has turned the corner from depression to mild recovery. But the jury is still out regarding the fate of this sector, as many skeptics fear a relapse in the spring after the Federal Reserve's $1.3 trillion mortgage-securities purchase program expires. The danger is that the expiration of the program at the end of March, which the Fed reaffirmed at the latest policy-setting meeting, will lead to higher mortgage rates and impose another weight on the fragile housing recovery. Our sense is that any increase in rates will be very modest, less than half-percent, and would not kill the nascent housing recovery if mortgage conditions improve and the economy starts to generate positive job growth. Both conditions should be met by the time the purchase program and revised tax credit expires.

We would feel much more confident about the future of the recovery if the fourth-quarter GDP report showed more consumer spending strength than it did. Personal consumption increased by a very modest 2 percent annual rate during the period, slower than the 2.8 percent increase registered in the third quarter and far weaker than usual coming out of a recession. But the 2.4 percent average increase over the past six months is actually stronger than that which occurred during the first two quarters coming out of the previous two recessions. What's more, the "cash for clunkers" program pushed forward car sales into the third quarter, so some payback in the form of weaker consumption in the fourth quarter was expected. In fact, all of the payback was in durable goods; spending on services and nondurable goods actually accelerated in the closing months of the year. All in all, the consumer sector held up reasonably well.

Equally encouraging is that consumer spirits are slowly, but surely, climbing out of the dumpster. Both the Conference Board and the University of Michigan came out with their household survey results this week, and both continued on an upward trajectory. The more encouraging of the two was the Michigan survey, which canvassed households later in the month than the Conference Board. Its index of consumer sentiment rose to just a tad below the level that prevailed in the final months of the last expansion. To be sure, a more upbeat attitude does not automatically translate into higher spending, but it is an encouraging omen and suggests a stronger spending rebound when employment picks up than otherwise.

The key, of course, is jobs, which continues to be the dark cloud overhanging the economic landscape. But the GDP report does offer a ray of hope that company hiring will start to pick up as well. One of the pleasant surprises of the report was the revelation that business capital spending is rebounding strongly. Outlays on equipment and software surged by 13.3 percent, the strongest increase since the first quarter of 2006. Just as inventory rebuilding requires more labor input, when companies obtain more machines and other equipment to generate output, they usually need more workers to operate them. Indeed, there is a strong historical correlation between capital spending and job growth. Simply put, while the headline GDP report clearly overstates the economy's underlying strength, there are enough positive elements in the report to inspire optimism.