Strength in the Face of Uncertainty
Monday, 14 January 2013
The data depict an economy that is poised for growth, despite higher taxes, new regulations, and continuing drama in Washington.
The tax deal adopted by Congress late January 1 ended some of the policy uncertainty said to be confounding economic decision makers. The measure prevents income tax rates from rising for a majority of Americans. It also raises payroll taxes by ending a temporary tax holiday put into effect two years ago in the wake of the economic meltdown. As a result, we now know that take-home pay will fall a few percent for nearly everyone, while households earning more than $450,000 will face higher effective tax rates.
Decision makers in homes and businesses have been operating under greater uncertainty than usual for the past few months. The gridlock in Washington was only part of the problem. The ongoing debt crisis and recession in Europe have also given reason for caution. So has a new regulatory environment for the financial sector, implementation of the new health care law, and doubts about the willingness of consumers to increase spending.
Fortunately, going into this uncertain period, the data paint a picture of an economy with underlying strength and the potential for faster growth. This, at least, is not likely to change soon.
AIER’s Business-Cycle Conditions indicators suggest that over the next six to 12 months the economy will continue to grow and unemployment will continue to fall. Our analysis finds that eight out of the 10 leading indicators that show a discernible trend are trending upward. The score for the leaders this month is 80, up from 73 last month. The cyclical score of AIER leaders, based on a separate mathematical analysis, fell a bit—from 78 last month to 75 this month. But it remains comfortably above 50, in expansionary territory.
Like last month, 100 percent of the coincident and lagging indicators are expanding, confirming that an economic recovery is well underway. Their cyclical scores are also in expansionary territory—94 for coinciders and 86 for laggers.
Still, businesses are holding back their spending.
Up to now, business investment in equipment and software has been the bright spot in this recovery. It had grown steadily since early 2010 at about a 10 percent annual rate before slowing in the third quarter of 2012. (See Chart 1 at left.) Overall, these business investments have contributed about a one-fourth of total GDP growth since the recovery began.
In recent months, however, businesses have become more cautious about capital expenditures. Investment in equipment and software shrank at an annual rate of 2.6 percent in the third quarter of 2012. Investment in new production facilities, which barely grew in the second quarter, remained unchanged in the third. New orders for core capital goods, one of AIER’s leading indicators, continued a downward trend seen since the beginning of 2012. (See section at page bottom)
There are two reasons that businesses expand capacity. They need to add capacity to meet expected growth in consumer demand, and they expect future income from new equipment to exceed financing costs.
Financing does not appear to be restricting businesses’ ability to invest. Interest rates are at historic lows. Commercial and industrial loans, a lagging indicator, continues to grow, as shown in the bottom chart in the second section below. Corporate profits are also high, and many companies have significant cash reserves. So companies have access to funds to finance capital investment.
Excess capacity also does not seem to be a barrier to new business investment. Companies appear to be reaching the limits of current capacity. In November, the latest month for which data is available, capacity utilization stood at 78.4 percent, close to its pre-recession peak of 80.6 percent.
Moreover, industrial capacity shrank in the immediate aftermath of the Great Recession and has grown only slowly since then. This is unique in U.S. postwar history. In all other recessions since 1945, growth of industrial capacity slowed, but continued. This suggests that capacity should be growing, even factoring in the current level of utilization.
Something else must be motivating business caution. The most likely candidate is the raft of uncertainty emanating from the on-going fiscal debate in Washington. The Congressional Budget Office, for instance, predicted that tax hikes and spending cuts associated with the fiscal cliff could push the economy back into recession.
Consumers, on the other hand, the driving force of the U.S. economy, have been pulling the recovery along.
Consumer spending, especially on durable goods, has been growing at a healthy pace. (See Chart 2 at right.) During the 12 months prior to November, durable goods spending grew 9 percent, in line with previous business-cycle expansions.
Even spending on new housing looks encouraging, rising steadily since mid-2011. In the third quarter of 2012, the most recent for which we have data, it rose at a 13 percent annual rate—about as fast as it usually increased during expansions in the past 30 years. Admittedly, this growth builds from a low level. During the recession, residential investment fell by half. But the direction is positive.
Unlike food and clothing, big-ticket purchases such as a new refrigerator or a new house often can be postponed. Since these purchases are often financed by borrowing, people tend to buy them when they feel relatively sure that they can meet the payments.
The data suggest that American consumers felt good about the future, at least up to the third quarter of 2012. People seem to have finally have brought their debt loads to a level where they may be comfortable borrowing again. The debt service ratio, which reflects required payments on mortgage and consumer debt, stood at 10.6 percent of disposable personal income in the third quarter of 2012. This is a striking decline from the pre-recession peak of 14 percent, and only a hair above the lowest level since data began to be collected in 1980. After the recessions of 1982 and 1991, consumers reduced their debt service ratio to 10.5 percent, then expanded borrowing again. (See Chart 3 at right.)
If the past 30 years are any guide, people may have shed as much debt as they comfortably can and may be ready to borrow again. And if people decide to increase borrowing, banks will be ready to lend. According to the Federal Reserve’s most recent Senior Loan Officer Opinion Survey on Bank Lending Practices (www.federalreserve.gov/boarddocs/snloansurvey), a majority of banks report increased willingness to make consumer installment loans. Banks also report that they are easing standards on consumer loans, such as credit cards and auto loans.
With consumers increasingly willing to borrow and banks that are willing to lend, we may be at the start of a consumer borrowing and spending resurgence. Higher consumer spending should give reason for businesses to ramp up production, increase investment, and expand hiring. Keep your fingers crossed.
Industry is making fewer investments in plant and equipment than it did a year ago. New orders for core capital goods, one of AIER’s leading indicators (top right), have been on a downward trend for nearly a year. The availability of financing doesn’t seem to be the problem. Interest rates are low and profits are high. And as one of our lagging indicators shows (bottom right), commercial and industrial loans continue to grow from recession lows.