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As expected, real GDP rose a moderate 2.2% in the second quarter, less than half the revised 4.9% pace of the first quarter. Strikes, weather delays and a slowdown in consumer spending helped to temper gains in equipment spending and exports. Imports also picked up dramatically. The bulk of those shipments ended up in inventories, however, and will eventually need to be drained.

An inventory drain is expected to hold growth in check over the summer. Strikes are also a problem for many businesses, but less of a problem for over-all economic growth than is portrayed in the news. On the upside, light vehicle production is scheduled to rise, and a return to more seasonal weather is expected to boost construction activity. Household spending is also expected to pick up on the heels of the recent spurt in home buying. Real GDP is forecast to rise 2.3% in the third quarter.

Prospects for the fourth quarter are better. Inventories are expected to stabilize, light vehicle production is expected to rise, exports are expected to reaccelerate, and equipment spending is expected to remain relatively robust. The only weak spot is the housing market, which is expected to moderate once weather losses are recouped. Real GDP is forecast to rise 2.8% in the fourth quarter.

The remainder of this month's report takes a closer look at the trade deficit and how the role of imports has changed in recent years. In sharp contrast to the early 1980's, the current rise in imports is actually contributing to our international competitiveness. Separately, the implications for inflation will be discussed. An economy that continues to upgrade is an economy that remains ahead of the game in terms of inflation.

A Look Back

The last time the U.S. ran large trade deficits was the early 1980's. Consumer spending outpaced overall economic growth and, in the face of sharp dollar appreciation, imports of consumer goods flooded the market to pick up the slack. The consumer goods share of imports trended up steadily with the consumption share of the U.S. economy. (See Chart 1.) Domestic market share plummeted, and large segments of our nation's infrastructure fell into disrepair. The auto industry was especially hard hit.

Deja Vu?

The trade deficit has again deteriorated sharply. The trade deficits of the 1990's, however, are of a clearly different breed than those of the early 1980's. Imports are being driven by strong gains in investment instead of consumption. The capital equipment share of imports has soared along with the investment share of the overall economy. (See chart 2.) Infrastructure has been improved instead of neglected and our global competitiveness has been enhanced instead of undermined.

*Capital equipment as a share of imported goods, excluding sales
**Business fixed investimet as a share of GDP

Risks–Recent dollar appreciation raises the risk that consumer goods could once again dominate the equation on imports. Japan and Germany are major auto producers and price competition has heated up in the auto sector. Problems with consumer balance sheets, however, suggest that consumers will have a tough time carrying this expansion in the months to come. This coupled with the on-going shift of Japanese production to the transplants should help to mitigate any increase that we see in consumer-related imports.

Moreover, investment is expected to remain strong. Profits continued to hit record highs in the first half of 1997, and the push to gain efficiencies has only intensified with increased global competition.

The Implications For Inflation

An economy that tends to invest more than it consumes is an economy that tends to foster extremely low inflation. Capacity additions tend to outpace economic demands, bottlenecks remain at a minimum, and inflation is held at bay. That is exactly what we are seeing today. Recent dollar appreciation and the price competition that it is generating will only exacerbate the situation. The shift of imports from consumer to capital goods is just one more reason to believe that inflation will remain in check during the balance of the year.

The Great Lakes Index (GLI) rose 1.8% in the second quarter, slightly behind the pace of overall GDP growth. Strike losses at GM and Chrysler, and poor spring weather more than accounted for the short-fall. The start of the spring construction season was particularly late. Household spending also slacked, but equipment spending and exports surged.

Preliminary data suggest that prospects for the current quarter are better. Light vehicle production is scheduled to accelerate, as auto makers push to recoup strike losses, and construction is expected to pick up with the onset of milder weather conditions. Equipment spending and exports are also expected to remain strong, and household spending is expected to post a moderate increase. The GLI is expected to rise 2.6% in the third quarter, 0.3% ahead of real GDP growth.

The outlook continues to brighten in the fourth quarter. Tight inventories, a mild rebound in sales, and a catch-up from earlier strikes are expected to keep light vehicle production on the rise, while equipment spending and exports remain strong. Home buying and building are expected to abate, however, once weather-related losses are recouped. On net, the GLI is expected to rise 3.2% in the fourth quarter, 0.4% above real GDP growth.

The remainder of this report takes a closer look at the trade deficit, and how shifts in the kinds of goods that we import have altered the role that deficits play on growth in this region of the country. Current deficits are more reflective of regional gains than losses.

Historically, a deteriorating trade deficit meant deteriorating economic conditions for this region of the country. (See Chart 4.)

The experience of the early 1980's was particularly hard:

–Imports surged;

–Exports plummeted;

–Domestic market share fell; and

–Heavy manufacturing profits deteriorated (Chrysler almost failed).

The region struggled to escape the grip of the 1980 and 1981-82 recession, unemployment remained stubbornly high, and the term “rustbelt” was born. (Chart 5)

By the late-1980's, conditions were improving. The dollar had peaked against the currencies of Japan and Germany, heavy manufacturers were well on their way to restructuring, and the trade deficit was narrowing:

–Imports were abating;

–Exports were accelerating; and

–Heavy manufacturing profits were recovering.

Unemployment was dropping, and the Midwest was beginning to show signs of an economic renaissance.

The early 1990's were even more rewarding. The trade balance briefly moved into surplus, providing a much needed offset to the 1990-91 recession, and heavy manufacturing profits began to hit record highs. Unemployment dipped to the lowest levels in the country, and the Midwest established itself as a model of economic efficiency.

Between 1995 and 1997, conditions appeared to deteriorate again. The dollar appreciated against the currencies of Japan and Germany, and the trade deficit deteriorated. This time around, however, the manufacturing of this region persevered; manufacturing profits continued to hit record highs, and unemployment continued to drop (to less than 2% in some parts of the region).

The easiest explanation is that our manufacturers are more efficient than they once were, and can better absorb dollar shocks than they once could. Recent gains in productivity growth in the heavy manufacturing sector provide testimony to this view. Shifts in trade to Latin America and Southeast Asia have also helped. Trade with those economies is less affected by dollar shifts than trade with the industrialized nations. The reality remains, however, that the trade deficit widened.

A better explanation is that the kinds of goods that we import today are somehow better for us than they were in the past. The trade deficits of the 1990's are essentially being used to finance investment instead of consumption. They are enhancing rather than undermining our competitiveness. Imports of consumer goods (largely autos) have dropped as a share of imports, while imports of capital equipment have surged. The result is increased productivity growth, rising capacity and a more efficient regional economy

Can It Last?–The dollar has appreciated sharply against the DM in recent weeks, and GM, Ford, and Chrysler have voiced their concerns about the dollar's strength against the yen. Pricing competition has already heated up, and the concern is that auto imports will surge as a result of those shifts.

As discussed in previous editions of this report, however, the transplants (U.S.-based Japanese plants) probably represent a greater threat to the Big 3 than imports. Much of the market share lost to the Japanese over the last year has gone to the transplants. The transplants now account for almost twice as many sales in the U.S. as imports.

Moreover, the dollar has come off the highs hit against the yen at the start of the year, and prospects are good that it will remain there. Washington appears willing to at least verbally defend a somewhat weaker dollar exchange rate, and Japan does not appear to be fighting it.

The Bigger Picture–Recent profit gains coupled with the on-going push to gain efficiencies suggest that investment, and hence imports of capital equipment, will continue to dominate the import picture for some time to come. Capacity additions will continue at an extraordinary pace, and our producers will continue to improve upon their own efficiency, even as global competition heats up.

August 8, 1997First Chicago

The First National Bank of Chicago

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