Why Is Greenspan Waiting to Raise Rates?

Until the Fed chairman sees evidence of inventory growth, he's skeptical the recovery is for real.
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On April 26, the economy gets its report card for the first quarter of 2002. Many economists and Wall Street pundits are predicting a decidedly passing grade. They believe the numbers from the Commerce Department will show that the economy grew by 5% to 6% in the first three months of the year. That's a spectacular recovery for an economy that grew by just 1.7% in the fourth quarter of 2001.

But don't expect

Federal Reserve

Chairman Alan Greenspan to be impressed. The Fed gets the government's data in advance, so it's a good bet that Greenspan had already seen the quarterly numbers on GDP when he told the Joint Economic Committee of Congress on April 17 that he's still waiting for evidence that the economic recovery is for real.

Greenspan's skepticism about the recovery is an important data point for investors trying to decide what to do about this confusing and frustrating stock market. A worried Greenspan means no interest rate increase from the Federal Reserve until, the current thinking goes, August. And his doubts about the real strength of the recovery need to be figured into the calculations of anyone trying to value stocks right now.

So what exactly is eating Alan?

In the Words of Greenspan

In a word, inventories. Greenspan -- like his predecessors -- usually tortures the English language in order not to give anything away about the direction of interest rates. But he was unusually clear about his concerns last week. "The behavior of inventories currently is the driving force in the near-term outlook," the Fed chairman said. "The pickup in the growth of

economic activity, however, will be short-lived unless sustained increases in final demand kick in before the positive effects of inventory investment dissipate."

Well, that's clear for an economist anyway. Let me try to fill in some of the leaps of logic and translate some of the jargon.

Inventory levels rise and fall with the economic cycle -- you might even say that they're a prime mover in the economic cycle from boom to bust. In boom times, companies order more parts and produce more finished goods because they're projecting that demand will continue to soar. That's exactly what U.S. businesses were doing in 1999. Gross domestic product grew by more than 8% in the fourth quarter of 1999, and companies, anticipating another year of bumper buying by consumers and corporations, built up inventories of raw materials and finished goods to meet anticipated demand.

Unfortunately, that demand never materialized. Economic growth in the first quarter of 2000 dropped to 2.3%, and after spiking to 5.7% in the second quarter, it fell to 1.3% in the third quarter, and closed the year at 1.9% in the fourth quarter.

False Start

At first, companies held onto that inventory in the belief that demand would come roaring back. But as the second quarter proved to be a fluke, and as a weak fourth quarter followed an abysmal third quarter, companies first stopped ordering new inventory and then started to liquidate the inventory that was sitting on their shelves at just about any cost.

Economic downturns are self-reinforcing, just as upturns are. As companies started to liquidate existing inventory, new orders took a nosedive across the economy -- and that, of course, led companies to cut inventories and orders for new inventory even further. Economic growth sank to an anemic 0.3% in the second quarter of 2001 and actually turned negative, at -1.3%, in the third quarter of the year.

Economists watching for a turn in the economy kept their eyes on inventory levels. Economic growth wouldn't resume, they argued on the evidence of past downturns, until companies stopped reducing inventories and instead started to replenish them.

Some indications now are that the economy reached the transition point when inventory reduction turned into inventory rebuilding earlier this year. (Inventory data from the Commerce Department are a lagging indicator. The most recent number -- for February 2002 - shows inventory levels falling by 0.1%, the same decline as in January.)

Perhaps the economic uptick the Commerce Department is expected to report this week was caused by companies rebuilding inventory. That's what Greenspan meant when he said that "The behavior of inventories currently is the driving force in the near-term outlook."

Economy at a Crossroads

Any inventory-based recovery, when it arrives, will put the economy at a crossroads. Companies always overreact when they reduce inventory in a downturn, much the same way they overstock when the economy is booming. If a normal inventory level is $100 million, for example, in a downturn a company might cut inventory to $80 million. Rebuilding that inventory to $100 million from $80 million gives the economy a short-term burst of growth.

To turn that short-term burst of growth into sustained growth, however, the orders designed to rebuild depleted inventories have to turn into orders to meet rising demand. "We have seen encouraging signs in recent months that underlying trends in final demand are strengthening," Greenspan told Congress, "but the dimensions of the pickup are still not clear."

That's putting it mildly. The picture that has emerged so far from this quarter's earnings reports is murky at best.

Forget about the technology sector. Even companies that have released decent results for this quarter haven't exactly tripped over themselves issuing positive future guidance. For example,


(MSFT) - Get Report

, the parent of the


Money Markets site I write for, lowered revenue and earnings-per-share guidance to Wall Street analysts for the next 15 months.


(INTC) - Get Report

confirmed that it would show revenue of $6.4 billion to $7 billion in the second quarter of 2002 (Wall Street consensus had been right in the middle at $6.7 billion) but didn't supply any numbers beyond the June period.


(NOK) - Get Report

cut its estimates for sales growth for the rest of 2002 to 4% to 9% from an earlier 15%.

Where to Look for Growth

But technology clearly isn't going to lead this economy out of the downturn, so these numbers aren't especially surprising. And they really don't shed any light on Greenspan's questions about the economy. The growth in demand that he's looking for will show up -- if it shows up at all -- at durables companies such as

General Motors

(GM) - Get Report

, at consumer products companies such as

Procter & Gamble

(PG) - Get Report

, at commercial lenders such as

Bank of America

(BAC) - Get Report

, and at raw materials companies such as


(AA) - Get Report


And here the recent data are more promising but still ambiguous.

For example, when it reported on April 16, General Motors raised its guidance on revenue and earnings for the full year -- to $5 a share in earnings vs. an earlier $4.07 -- on strong domestic demand and market share gains. That's great for General Motors and anyone who owns shares -- but it would be a more solid indicator of demand if


(F) - Get Report




were doing better as well.

Procter & Gamble CEO A.G. Lafley said the company won't meet its goal of a 4% to 6% sales increase in the fiscal year that ends in June -- but said he's confident the company would hit the goal in 2003. Again, good news, but again, like General Motors, Procter & Gamble is in the midst of a restructuring that has led to higher guidance on earnings and sales in each of the past five quarters. So investors are left to wonder if the growth that Procter & Gamble is reporting is a function of market share gains or increased demand for consumer products in general.

Bank of America's April 15 earnings report was more pessimistic than the view from either General Motors or Procter & Gamble. The bank beat analyst expectations for the March quarter by 4 cents a share and then promptly said it wasn't seeing any pickup in loan growth. Bank of America CFO James Hance explicitly linked lack of loan growth to continued paring of inventory. The bank won't see loan growth until inventories pick up, he said. "You really need to see a building of inventories."

Alcoa, on the other hand, said that the aluminum market would be "challenging" for the rest of 2002 -- which was positively good news, given how absolutely horrible the company's market was in 2001. Comparing the first quarter of 2002 with the first quarter of 2001, the company took a double wallop from falling demand and falling prices. The price of primary aluminum, for instance, fell 14% from the first quarter of 2001 to the first quarter of 2002. But both demand and price may have taken a turn for the better in the first quarter from the low levels in the fourth quarter of 2002. The price of aluminum was up during the period from the price in the December period.

I've cited the conflicting views from these four companies not to confuse you but to illustrate that the situation is genuinely unclear. It appears we're in the early stages of a recovery, rather than an upward blip caused by inventory rebuilding. But at this point the glass is just as likely to be half-empty as half-full.

Greenspan's caution is absolutely appropriate -- this recovery is fragile and the data are very sketchy. The Fed is trying, in consequence, not to move too quickly. That seems a reasonable stance for investors as well.

More data will clarify the economic picture. More data are on the way even as early as this week. Positioning your portfolio for an upturn by buying the strongest companies in the strongest sectors makes sense to me in this environment. But I certainly wouldn't try to force anything before the market and the economy are ready.

Jim Jubak appears Wednesdays on CNBC's "Business Center" at 6 p.m. EST. At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Intel, Microsoft and Nokia. He does not own short positions in any stock mentioned in this column.