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Beige Book Report: Cleveland

March 15, 1989

Developments of recent weeks have not altered the outlook for the economy and for inflation, according to Fourth District respondents. They are optimistic that nonresidential fixed investment will increase more this year than last because of further strengthening in traditional capital goods industries. Retailers, buoyed by much stronger-than-expected spending since last fall, are optimistic over consumer spending at least through the spring. Financial industry respondents do not yet see signs of slower loan growth because of higher interest rates. Thrifts are very competitively pricing CDs, although many experienced another loss of deposits in February.

The Economy
Respondents still expect a slightly slower growth rate in output this year than last, and a slightly higher inflation rate. Even the most optimistic of the forecasters remain confident about their real GNP forecast of slightly more than 3% growth this year. One respondent, however, expects that there are downside risks to his slower growth forecast if interest rates continue to rise, and another believes that higher interest rates make his forecast of no- growth late this year more plausible.

Inflation
Further upward cost/price pressures especially in manufacturing, are expected in 1989 by most respondents. Steel prices are expected to rise further this half before weakening later in the year, and strong demand for heavy-duty trucks, bearings, and special industry machinery is expected to boost prices more in 1989 than in 1988. Many manufacturers are expected to operate at or close to capacity, and will attempt to pass through higher costs of materials incurred last year when conditions may not have been as favorable. Wage rates in retailing are rising because of a shortage of workers. An alternative view of inflation, however, anticipates moderating inflation because supply will increase faster than demand and energy and food prices will increase less this year than last.

Manufacturing
Capital goods prospects for l989 are strong, especially for traditional capital goods industries. The bearings industry is still operating at full capacity and may be allocating its output for most of the year. Some industrial equipment producers are also operating at or close to capacity, with orders and backlogs still rising. "Boom" conditions mark the heavy-duty truck business, with operating rates the highest since the late 1970s. A producer of motors and engines reports that the surge in orders last quarter has continued into February and March, although operations are not close to full capacity. Nevertheless, their orders and shipments will be several percent higher than they previously forecast. Strength in most traditional capital goods industries has led one economist to conclude that his forecast of a 6% increase in real nonresidential fixed investment this year could be on the low side. Industry respondents generally do not expect that higher interest rates will dampen capital goods at least this year. They uniformly report that tightness in capacity is being met by productivity improvements and "de-bottlenecking."

Steel producers have been operating at or near capacity, and expect to continue to do so at least through the second quarter. Flat- rolled steel products are still on allocation, although there is excess capacity for steel consumed by the construction and petroleum industries. Lead times are lengthening to as much as 10 weeks because of strong orders that may reflect hedge-buying. Steel respondents expect that a let up in consumption and in inventory buildup in the second half will ease pressures on operating rates and end the allocation of steel now in tight supply.

Consumer Spending
Nonautomotive retailers have been surprised by strong sales since last fall, which they expect to continue at least into the spring months. Inventories, however, will be built only cautiously. A major retailer reported that sales strength continued in February, and he expects March and April sales will show about the same rate of increase. Another retailer is concerned that further increases in interest rates will choke demand because of the link between consumer debt and interest rates.

Auto dealers report February sales were averaging a little below average for this time of year and assert that publicity about rising interest rates has begun to affect sales. Many auto dealers are offering special financing plans at below-market rates. Dealers are generally optimistic over spring sales, however, unless interest rates continue to increase.

Financial
Higher interest rates apparently have had little visible effect on borrowing activity. Most lenders believe interest rates on loans have not risen enough to slow loan growth, although some bank economists expect that the latest jump in interest rates, especially mortgage rates, will slow borrowing later this year. According to one economist, the only apparent effect of higher interest rates so far has been in trade rather than in domestic demand; he still expects a 3% real GNP growth rate this year, with a considerably slower second half because of higher interest rates.

Thrift institutions experienced another net deposit outflow in February, although not as severe as in January. Even some large, well-capitalized thrifts have outflows nearly as large or larger than in January. A large thrift reversed its massive January outflow in February, but solely on the basis of its newly introduced CD that is competitive with Treasury bill yields. Another experienced its second successive monthly net inflow of deposits by very aggressive pricing of its CDs.