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The business situation.


REVISED estimates show that real GNP increased at an annual rate of 4 percent in the third quarter of 1987; the preliminary estimates had shown about the same rate of increase (table 1).1 The broad picture of the economy as sketched in the last month's "Business Situation" was essentially unaltered even though components of GNP underwent revisions.

1. Quarterly estimates in the national income and product accounts are expressed at seasonally adjusted annual rates, and quarterly changes in them are differences between these rates. Quarter-to-quarter percent changes are compounded to annual rates. Real, or constant-dollar, estimates are expressed in 1982 dollars.

The largest upward revision was in farm inventory investment ($6 billion), and the largest downward revision was in Federal nondefense purchases ($5 1/2 billion). These offsetting revisions reflected the September data on transactions of the Commodity Credit Corporation.

The increase in the GNP price index (fixed weights) was revised up to 3 1/2 percent from 2 1/2 percent. The revision was mostly due to upward revisions in prices of residential and nonresidential structures and of personal consumption expenditures, especially food, clothing, and services.

Corporate profits

Profits from current production-- profits before tax with inventory valuation adjustment (IVA) and capital consumption adjustment (CCAdj)--increased $17 billion in the third quarter, following a $3 billion increase in the second. In both quarters, domestic nonfinancial corporations dominated the movement in profits; small-to-moderate declines in domestic profits of financial corporations were largely offset by increases in profits from the rest of the world.

Profits before tax (PBT) increased $13 1/2 billion in the third quarter after an increase of $11 1/2 billion in the second. The third-quarter difference between profits from current production and PBT is due to the IVA, which increased $4 billion (to negative $16 billion) after a decline of $8 1/2 billion. The IVA, which is not reflected in PBT, converts the value of inventory withdrawals from the predominantly historical costs that underlie PBT to current replacement costs. Largely due to decelerations in petroleum and wholesale food prices, current replacement costs of inventory withdrawals were closer to the costs that underlie PBT in the third quarter than they were in the second quarter.

In nonfinancial corporations, both real gross product and profits per unit increased. The increase in unit profits was associated with a modest increase in unit prices and flat unit costs. Profits as a share of gross product increased to 10 percent, the highest level in more than 2 years. Cash flow from current production--undistributed profits with IVA and CCAdj plus capital consumption allowances with CCAdj--increased $11 billion after three consecutive quarterly declines.

Trade profits rebounded partially after a very sharp drop in the second quarter; the increase was largely in wholesale trade and retail automobile dealers. In manufacturing, profit increases were large and widespread; only motor vehicles registered a substantial decline, perhaps partly reflecting sales incentive programs in the third quarter. (See "Motor Vehicles, Model Year 1987," elsewhere in this issue.)

Government sector

The fiscal position of the government in the national income and product accounts deteriorated in the third quarter of 1987, as the combined deficit of the Federal Government and of State and local governments increased $3 billion (table 2). The deterioration was the result of a decline in the State and local surplus.

The Federal sector.--The Federal Government deficit declined $2 billion in the third quarter to $137 billion, as expenditures declined more than receipts.

Receipts declined $2 billion, following a $43 1/2 billion increase in the second quarter. This unusually large swing was due to the effects of the Tax Reform Act of 1986 on personal tax and nontax receipts. This act subtracted $22 billion from the change in personal tax payments in the third quarter after adding $21 billion to the second-quarter change. Most of the swing resulted from a sharp drop in declarations (estimated tax payments) and net settlements (final tax payments less refunds). These payments were large in the first half of the year, reflecting the acceleration of capital gains realizations into 1986. (For more information, see the discussion in the July 1987 "Business Situation.")

Corporate profits tax accruals and contributions for social insurance increased $5 billion each, reflecting growth in incomes. Indirect business tax and nontax accruals declined slightly as a result of a $1/2 billion decline in customs duties.

Expenditures declined $4 billion, following a $12 1/2 billion increase in the second quarter, when purchases of goods and services and grants-in-aid to State and local governments recorded strong increases. National defense purchases increased only $1 billion in the third quarter, compared with $7 billion in the second; the deceleration was in services other than compensation. Nondefense purchases declined $2 billion in the third quarter, following a $5 1/2 billion increase in the second; the swing was in purchases other than for agricultural commodities. Purchases of agricultural commodities by the Commodity Credit Corporation declined about the same amount in both quarters. Grants-in-aid declined $2 1/2 billion in the third quarter, following a $3 1/2 billion increase in the second; the swing was largely due to medicaid grants. On balance, all other expenditures, taken together, declined $1 1/2 billion; increases in transfer payments and net interest paid were offset by a decline in subsidies less the current surplus of government enterprises. The decline in the latter category was largely accounted for by a decline in agricultural subsidies.

Cyclically adjusted surplus or deficit. --When measured using cyclical adjustments based on middle-expansion trend GNP, the Federal fiscal position moved from a deficit of $161.8 billion in the second quarter to a deficit of $166.9 billion in the third (see table 2 on page 18). The cyclically adjusted deficit as a percentage of middle-expansion trend GNP increased from 3.7 percent in the second quarter to 3.8 percent in the third.

The State and local sector.--The State and local government surplus declined $5 billion in the third quarter to $45 1/2 billion, as expenditures increased more than receipts. An increase in the deficit of other than social insurance funds more than accounted for the total decline.

Receipts increased $6 billion, compared with $19 billion in the second quarter. The deceleration was due to the indirect effects of the Tax Reform Act of 1986 on personal tax and nontax receipts and the decline in Federal grants-in-aid. Personal taxes declined $1 billion, following a $7 1/2 billion increase in the second quarter. The tax act raised second-quarter payments to the extent that taxpayers shifted realizations of capital gains into 1986. Indirect business taxes increased $7 billion, somewhat more than in the second quarter, and corporate profits tax accruals and contributions for social insurance increased at about the same pace as in the second quarter.

Expenditures increased $10 1/2 billion, compared with $9 1/2 billion in the second quarter. Most of the increase was in purchases of goods and services, which increased $10 billion, $1 1/2 billion more than in the preceding quarter. The acceleration was partly due to purchases of structures, which declined less in the third quarter.

Leading Indicators

BEA's composite index of leading indicators declined 0.2 percent in October according to estimates based on 9 of its 11 component series, following no change in September. The stock price index made, by far, the largest negative contribution (table 3). The unusually large negative contribution of the stock price index, -1.06, will be reduced to -0.87 in the revised estimate to be released next month when the two missing series--change in inventories and change in credit-- become available. (Elsewhere in this issue, "Composite Indexes of Leading, Coincident, and Lagging Indicators" describes the methodology used to construct the composite indexes and explains, among other things, how the calculation of net contribution is affected by the number of series that are available.)

Six of the other eight components increased in October, with average workweek making the largest positive contribution. Average workweek bounced back up to 41.1 hours after a 0.6 drop in September; the September decline reflected the fact that the survey on which the data are based was taken during the week that included Labor Day.

Because the October decline in the stock price index was so large and because a similar decline in November will affect next month's leading index, this component of the leading index is discussed in some detail below. Before turning to this topic, however, it may be helpful to consider some general aspects of interpreting changes in the leading index.

Interpreting changes in the index.-- Analysts following the cyclical indicators approach interpret cyclical peaks and troughs in the leading index as signals of subsequent cyclical peaks and troughs in aggregate economic activity. The first task facing the analyst, then, is to identify cyclical turning points in the leading index.

Not every decline after a protracted upward movement in the leading index indicates that a cyclical peak has been passed. On the basis of revised estimates, 10 peaks may be identified in the leading index for the period 1948-86, yet upward movements in the index were interrupted by a decline 41 times in that period; in other words, only 25 percent of these declines in the leading index were actually associated with incipient contractions in the index. After a protracted upward movement in the index, two or three consecutive monthly declines are far more likely to signal a downturn: Two consecutive declines occurred 14 times in 1948-86, and three consecutive declines, 12 times.

For the subperiod April 1975 (when the index in its current form was introduced) through December 1986, the leading index registered 2 peaks. In this subperiod, revised estimates registered 20 1-month declines, 4 2-month declines, and 4 3-month declines. (Estimates available to contemporaneous observers attempting to identify turning points showed a roughly similar pattern: 28 1-month declines, 6 2-month declines, and 3 3-month declines.)

In general, then, the more protracted the decline in the leading index, the more likely that a cyclical peak has been passed, but focusing only on the most recent change in the index or on the number of consecutive declines would mislead analysts: All cyclical peaks in the index would be identified by such a procedure, but some erratic movements in the index would be interpreted, incorrectly, as indicating that a peak had occurred. Thus, in attempting to identify turning points, analysts go beyond such mechanical procedures to consider not only the direction of the index's movement but also the movement's depth, duration, and diffusion--the "3 D's" of the indicator approach. (These "3 D's" are candidates for discussion in a future issue of the SURVEY.)

When a peak in the leading index has been identified, the analyst infers that a decline in economic activity is likely. Over 1948-86, however, two peaks (and troughs) in the revised leading index were not followed by peaks (and troughs) in aggregate economic activity. Thus, it is by no means certain that a peak in the leading index, once it is identified, will be followed by a peak in aggregate economic activity. It should be noted, however, that while the two "false" peaks in the leading index, in 1950 and 1966, were not followed by peaks in aggregate economic activity, they were followed by noticeable slowdowns.

At least two other aspects of the indicators approach deserve mention. First, analysts interpret a peak in the leading index as signaling a subsequent peak in aggregate economic activity, but "subsequent" is not precisely defined. On average over 1948-86, peaks in economic activity occurred 9 1/2 months after a peak in the composite index. This average, however, conceals almost as much as it reveals; downturns in economic activity trailed downturns in the leading index by as little as 3 months and as much as 23 months. Second, the size of changes in the leading index is not always indicative of the size of subsequent changes in aggregate economic activity. Thus, for example, the relatively mild recession of 1953-54 was preceded by a very sharp drop in the leading index, but the relatively severe recession of 1973-75 by only a moderate decline.

Stock prices in the leading index.-- Stock prices are represented in the leading index by the monthly average of daily closing levels of Standard and Poor's index of stock prices, 500 common stocks. This index is broad-based (comprising the stock of 400 industrial, 40 utility, 20 transportation, and 40 financial corporations) and closely approximates the average price level of all the stocks listed on the New York Stock Exchange.2

2. The Standard and Poor's index, rather than some other stock price index, was selected for inclusion in the leading index because of its breadth of coverage, its availability over a long period, and its performance as a leader. The index is included in the blue pages of the SURVEY (p. S-16) as well as in Business Conditions Digest (pp. 13, 69). For a more detailed description of the index, see Handbook of Cyclical Indicators, pp. 24-25.

From the recession trough in November 1982 to August of this year, the stock price index included in the leading index increased 138 percent, far exceeding the gains that had been made 57 months after any of the previous seven business cycle troughs. Even after a fall in stock prices in September and the dramatic decline in October that took the index back to its February 1987 level, stock prices were still 103 percent higher than in November 1982.

As was seen in table 3, the stock price index made substantial contributions to the upward path of the leading index through August. In 2 of the first 10 months shown in the table, it was responsible for the largest net contribution of any component; in 4 other months, the second largest. If the stock price index were removed from the leading index, however, the month-to-month direction of change in the composite would have been altered in only 1 month (February).

The stock price index has led business cycle turns, on average, by 9 months at peaks and 4 1/2 months at troughs. Of the last 16 business cycle turns, the index signaled all but one peak and one trough (namely, the peak and trough of the very short recession of 1980). However, the index has also given eight false signals of business cycle turns--four in the 1960's, two in the late 1970's, and two in the 1980's.

At least two economic rationales (not mutually exclusive) may be offered for the tendency of the stock price index to reach cyclical peaks and troughs in advance of aggregate economic activity.

First, the traditional rationale is that stock price changes may reflect expectations that influence future economic behavior. The precise nature of the "expectations-stock prices-economic behavior" mechanism is rarely described in detail, but one possible scenario may be sketched. Investors' expectations of future profits may fall--perhaps because actual profits are lower than had been anticipated or because of increases (actual or anticipated) in interest rates. To the extent that stock prices are determined by expected profits, stock prices fall. Lower expected profits also induce businesses to revise downward their investment and hiring plans. The lower investment and employment that result when these plans are implemented initiate a contraction in aggregate economic activity. Note that in this rationale it is expected profits that are a causal force; stock prices simply mirror those expectations.

A second rationale for why the stock price index leads aggregate economic activity is more straightforward and attributes causation to stock prices themselves. Changes in stock prices cause changes in wealth; these wealth changes, in turn, affect spending decisions, but the full extent of this effect is not felt immediately.

Table: 1.--Revisions in Selected Component Series of the NIPA's, Third Quarter of 1987

Table: 2.--Government Sector Receipts and Expenditures

Table: 3.--Net Contributions of the Individual Components to Changes in the Leading Index
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Title Annotation:third quarter of 1987
Publication:Survey of Current Business
Date:Nov 1, 1987
Previous Article:Constant-dollar inventories, sales, and inventory-sales ratios for manufacturing and trade.
Next Article:National income and product accounts tables.

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