Data warn against grasping at green shoots of recovery

Yesterday's news that US retail sales fell 1.1 per cent in March is a blow to the idea that green shoots in the world economy herald the start of recovery.

The report is still consistent with the idea that the rate of decline has slowed from the precipitous pace seen in the final months of 2008, when it looked as if the world economy was falling off a cliff.

But it offers a reminder that the economy could continue to decline at a slower pace for some time and that the shape of the eventual recovery remains uncertain. There remains a risk of an extended period of weak growth punctuated by periods of contraction, as seen in Japan in the 1990s.

“The sense of a ball falling off the table,” is drawing to a close, Lawrence Summers, director of the White House National Economic Council, said last week. But “how strong, how rapid the turn will be – that is a less clear question”.

The green shoots story is pegged on an inventory cycle. Production fell so sharply globally in late 2008 that it is now running below final sales.

That is allowing companies to liquidate excess inventories. As ratios of inventories to sales return to more normal levels, they are likely to increase output again – and employment should follow, with a lag.

Since the downswing of the inventory cycle was unusually brutal, the inventory-led element of the upswing could be quite vigorous too.

However, this is not a normal inventory-led business cycle. It combines a financial crisis with balance sheet adjustments in both the household and financial sectors.

Moreover, even the inventory cycle is unlikely to turn until there is some stabilisation in sales and final demand.

The Barack Obama fiscal stimulus will fill some of the gap left by contracting private demand. But with consumer spending still accounting for more than 70 per cent of the US economy, US consumption remains critical. In the last two quarters of 2008, the US consumer suddenly pulled back – with consumption falling at an annualised rate of roughly 4 per cent.

In January and February consumer spending suddenly appeared to stabilise, with retail sales up in both months. This raised hopes that consumer spending could be bottoming out – providing a firm foundation for an inventory-led turn in output. However, the 1.1 per cent fall in retail sales in March – with declines in almost every category – raises fresh doubts.

Not too much should be read into any one month's data. “We should look at the quarter as a whole,” said Steven Wietling, an economist at Citigroup. “Spending has been very weak but stabilising.”

Confidence has edged higher from rock-bottom levels. The household credit squeeze, while still intense, may not be getting tighter. Spending on cars may be artificially depressed. Mortgage rates at multi-decade lows are allowing households to refinance debts at lower rates.

However, consumption could still fall further. The economy is losing more than 600,000 jobs a month. Total hours worked are falling sharply and resilient wage growth could also weaken, resulting in ongoing declines in labour income.

The boost to consumers from lower energy prices and early tax rebates is fading, though stimulus tax cuts and other government transfers will provide non- labour income.

Moreover, the US household savings rate is still only just above 4 per cent. That is up from about zero. But it is likely to move higher, given the destruction of household wealth and high debt levels.

From mid-2007 to the end of 2008, US household wealth fell by $12,885bn. Since then it has probably fallen further.

A gradual drift up in the savings rate – particularly one accommodated within rising incomes – is perfectly consistent with stable or slowly rising consumption.

But if the savings rate rises quickly when incomes are not growing, all bets are off. Even in a less extreme case, multi-year fiscal stimulus may be required to underpin recovery.