Recent data releases continued to indicate that the economy is making slow progress towards recovery. However, we are only just in the beginning stages of reversing the damaging effects of the recession. Many sectors and industries had such deep and broad declines that it may take a long time to return to pre-recession levels. Residential housing continues to be a drag on gross domestic product, capacity utilization in the industrial sector remains at historic lows, and retail inventories have yet to be fully restocked.
The experience from past recessions suggests that the bigger the decline, the bigger the eventual recovery. Many companies have weathered this economic crisis by slashing payrolls, scaling back production, and depleting inventories. The silver lining in all of this gloom is that once the economic expansion gets going again, it could continue for awhile because there is so much ground to recover.
Housing showing signs of stabilization, but still a drag on growth
The Commerce Department reported that new construction of U.S. housing units was essentially flat in September, as housing starts ticked up to 590,000 from a revised level of 587,000 in August. (A housing start is when the excavation begins for a new residential dwelling.)
Why are housing starts an important gauge of the health for the U.S. economy? Most homebuilders don’t start building a house until they are reasonably confident it can be sold at completion. Therefore, trends in the rate of housing starts can be an indication of the level of demand for housing and the outlook for the construction industry. In addition, each time a house is sold it can have a ripple effect through the economy as homeowners buy new furnishings and appliances for their new house.
Dating back to the first quarter of 2006 when housing starts peaked at 6.36 million units, residential fixed investment (purchases of private residences and residential equipment that is owned by landlords and rented to tenants) has had a negative contribution to gross domestic product (GDP) for 14 straight quarters. In other words, declining activity in residential construction has been a drag on economic growth for over three years.
Prior to December 2008, the rolling 3-month total of housing starts had never fallen below 2 million units since 1959 when the Commerce Department began keeping records of housing activity. Throughout 2009, the rolling 3-month total of housing starts has stayed well under 2 million units. We are still a long way from the historical 3-month rolling average of 4.56 million units, but the housing sector is showing signs of stabilization. The rolling 3-month total of housing starts has been increasing since bottoming in May at its all-time low of 1.55 million units.
Another signal of increasing activity in the housing sector came from the National Association of Realtors (NAR), which reported that sales of existing homes increased 9.4% in September to a seasonally adjusted annual rate of 5.57 million units. While last month was the highest rate of monthly sales since July 2007, much of the momentum came from first-time homebuyers as they hurried to take advantage of an expiring tax credit.
The NAR also reported that the median sales price fell 1.4% to $174,900. Distressed sales (foreclosures and sales where the proceeds fall short of the balance owed on the property) accounted for 29% of sales in September, continuing to put downward pressure on home prices. Last month’s drop in home prices, however, was the smallest year-over-year decline since July 2008.
While the upcoming expiration of the $8,000 first-time home buyer credit may dampen the near-term enthusiasm of homebuyers, many of the underlying fundamentals remain favorable. Even though long-term mortgage rates increased over the past week, they remain low by historical standards. Other measures of housing affordability, such as the Housing Affordability Index from the National Association of Realtors, also remain well above long-term averages.
Industrial production, capacity utilization showing improvement
According to the Federal Reserve, U.S. industrial production rose 0.7% in September and 2.8% in the third quarter. The annualized rate of increase in Q3 was 11.8% — a marked improvement from when industrial production was falling this past January at a 21.1% annualized 3-month rate.
Increased production in motor vehicles and parts helped lift industrial production in September. Even better news was that the gains were also widespread outside of autos. Overall production excluding motor vehicles was up 0.4% last month.
The increase in industrial production helped push capacity utilization to 70.5% in September for the third monthly gain in a row. While last month’s capacity utilization was above the all-time low of 68.3% reached in June, it’s still below the lows of any prior recession over the past four decades — and well under the historical average of 81.1% since records began in 1967.
There is still considerable slack in the U.S. industrial sector, but the upside is that manufacturing activity can increase substantially before the utilization rate gets so high as to raise concerns about inflationary bottlenecks in production.
Inventory restocking could boost economy
Another sign of the lagged effects of the recession is the excess inventories, built-up over the past several years, which continued to rapidly deplete. As consumer demand was weak during the recession, many companies cut production and instead worked off inventories. Why add to inventories if demand is uncertain and the economic outlook bleak?
Retail inventories fell 2.3% in August and have had year-over-year declines for 11 straight months. However, much of the decline in August was the result of the Cash for Clunkers program. Excluding autos, retail inventories only fell 0.3% in August.
Retail inventories have now fallen so much that the retail inventory/sales ratio is at 1.39, its lowest level since records began in 1967. Businesses have been remarkably adept at quickly slashing payrolls and inventories in reaction to the declining sales wrought by the recession. However, if the economy continues to improve and retail sales show even a small uptick, businesses will need to restock depleted inventories. This, in turn, would give a boost to economic growth and explains why many economists and market commentators think this could be an inventory-led recovery.
Long, winding road to recovery
Clearly, there continues to be substantial slack in the U.S. economy. Housing starts, industrial production, and retail inventories have fallen precipitously over the last two years. While the depth of the declines is unsettling, it also points to the possibility of a strong rebound as the economy gingerly exits from the downturn and takes steps towards growth.
Signs continue to emerge that the slack is beginning to be put to use. The Conference Board, a business research group, reported that its Index of Leading Economic Indicators rose 1.0% in September for the sixth consecutive monthly increase. The 5.7% increase over the past six months was the strongest since 1983.
Regardless of the shape of the eventual economic recovery, the path back to growth will likely be winding and uneven. But even a halting path back to expansion is a welcome and encouraging new direction.