It's the inventory, stupid.
That's the bottom line for Diane Swonk, chief economist of
Bank One, who tells today's
Daily Interview that things are looking up.
Even if first-quarter GDP shows negative growth, Swonk says she isn't concerned. Flat or negative GDP growth, she maintains, may be good news because it will indicate that businesses are busy working off excess inventories and are on the verge or restarting their assembly lines. She points to yesterday's release of a 0.4% increase in industrial production in March, as opposed to the 0.1% decline that economists expected, as a positive sign.
Swonk adds that the fears of a recession are unfounded, and that we are really at the tail end of a classic inventory cycle. She sees the markets now poised for rapid growth in the second quarter.
TSC: Can you put the economic indicators released Tuesday in perspective? The Consumer Price Index, as expected, rose a scant 0.1% in March. Industrial production, instead of declining 0.1%, rose 0.4%. Housing starts came in at 1.613 million, weaker than expected. What do these numbers tell you about where the economy is headed? Swonk: The production number is the most important one right now. For the last five months leading up to March, the vehicle sector has been really dragging down production. I believe the turnaround in vehicle production that we saw in March is very important because that's where the biggest inventory problems were, and, in fact, it's where the biggest employment losses have been.
This is not just a one-month blip but an inflection point. We have the production schedules for the second quarter, which are the first scheduled increases in over a year. This is an important turning point.
At the same time we have been revising down inventories, we have been seeing, surprisingly, rising demand throughout the quarter.
Inventory cycles are very complex. When you are taking inventories down while at the same time people are consuming more, that's not a recession. That's just a stage for significant rebounding growth going forward.
TSC: Many economists say that once you begin to see inventory liquidations, that signals the end of a downturn. In fact, some economists say the steel, packaging and paper industries have just about worked off their excess inventories. But what about the negative GDP growth that most economists are expecting out of the first quarter? Swonk: The first quarter is going to be very confusing to many because GDP growth is listing close to zero. But if GDP growth were stronger because inventories were drained less rapidly, that would actually be bad news, because then the Fed might not cut interest rates.
We already know that final sales accelerated at the end of the quarter and that consumer spending continues to accelerate. This is helping to draw down inventories, which is taking away from growth and hurting production and GDP comparisons -- but not hurting sales.
The net result is a very weak current quarter -- but it is a result of the exact kind of combination of weakness that will set the stage for stronger growth going forward because it means that inventories are out of the way. Consumers, meanwhile, have not died. They continue to be king. You put the two together and you have production back on an upswing again. That's very important.
TSC: You remain optimistic about consumer spending. How can you expect consumers to continue to spend amid falling markets, earnings shortfalls and extensive layoffs? Swonk: The underlying trends in employment and income are still positive. We started the slowdown in an economy with an exceedingly tight labor market. That acts as an enormous shock absorber when you do start to have layoffs. There are places for people to go when they lose their job.
With regards to the other issue, the stock market, context is important. We made a lot of money in the 1990s, and that also provided an enormous cushion when the markets went bad. You'd have to really damage peoples' capacity to spend.
Those who are arguing a negative wealth effect aren't really looking at the data. Consumer spending has slowed because a lot of the things that boosted consumer spending over the past couple of years, like low energy prices and interest rates, have reversed a bit. But now they are starting to come back, along with mortgage refinancing and easy credit. And in fact real estate values in New York have surged to record levels, and that is where the wealth effect should be the greatest. People have continued to buy homes and cars, which take a lot of confidence to buy.
But it almost doesn't even matter if there is consumer demand or not, because now there are no inventories. But there is some demand out there. Consumer spending accelerated in the first quarter over the fourth quarter. But if you don't have any inventory, you don't need much more than to revive production.
This was a classic inventory cycle -- not a recession. It's a very fine line, but it's very important to understand the difference between the two. In an inventory cycle, as long as you keep spending and the multipliers from it never get large enough to damage demand, you get through it. That's exactly what happened.
This production number really proves that we hit the inflection point in the first quarter. And inflection points are cross points, and that could mean that we are close to zero growth. It's not out of the range of possibility to even see a negative GDP number on the first quarter. But that is by no means the indication of a reversionary quarter.
TSC: What do you say to those economists and market commentators who are saying we could be in a recession? Swonk: I'm always amazed at the number of people who are talking the "R" word without having it in their forecasts. There are actually very few economists who have a recession in their forecasts.
Morgan Stanley is one of the few.
We have consistently argued that not only didn't we see a recession in the cards, but the weakness we saw at the start of the year would set the stage for much stronger and resilient growth by year-end.
And it's happening even faster than we thought. We thought we'd have a transition quarter in the second quarter, and if growth comes in with the kind of inventory drain it looks like we'll get on the first quarter, the second quarter is going to be stronger than many imagined.
