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Economic Insights

The current pace of expenditures on property, plant, and equipment dampens the likelihood of an accelerated economic recovery.

The emerging picture on capital spending is far from encouraging. To be sure, a number of temporary influences beset the quarter just past, a circumstance that likely will produce a bounce in the spring and possibly the summer quarter as well. But behind such quarter-to-quarter swings, fundamentals point to a still slow pace of such spending and, by implication, in the general recovery as well. Matters could be worse. The capital spending picture is not so bad that it will scotch the general recovery. At the same time, it argues strongly against any expectation of a general economic acceleration, much less a return to historical real growth rates, anytime soon.

Short-Term Swings   
Recent statistics certainly make for grim reading. During the six-month period ended March 31, 2015 (the most recent period for which data are available), sales and orders of new non-defense capital goods have fallen at an annual rate of about a 5.0%. Were it not for the volatile aircraft segment, orders would have fallen at an annual pace of 11.3%. Broader measures, reported in the country’s national income and product accounts, show even steeper declines. According to these, sales after inflation barely increased during the first quarter this year, expanding at a rate of a mere 0.1% annually in real terms. Computer sales to business fell at a whopping 29.2% annual rate, while sales of industrial equipment fell at a rate of 7.9%. New real commercial and industrial construction fell at a startling 23.1% annual pace, and the greatest drop, a 48.7% decline, was recorded for wells and mining. The only broad category that increased substantially was spending on intellectual capital, which in real terms expanded at a rate of 7.8%—and even that was a slowdown from the almost 10% rate averaged during the two prior quarters.1

These reports, do, however, overstate the problem. Capital spending in recent months, like much of the rest of the economy, suffered unduly from three more or less transitory influences. A protracted dock strike on the West Coast effectively blocked a major avenue for exports of capital equipment, especially computers, not a small part of the whole. Inordinately cold and stormy weather during the first three months of the year had a depressing effect on equipment sales as well. It had a still more depressing effect on construction, explaining the remarkable decline recorded in that area during the quarter. The precipitous drop in oil prices during the second half of 2014 prompted the industry to slow exploration activity abruptly during the latter months of that year and the opening months of this one, leading to the tremendous drop in spending on all sorts of drilling and pipeline equipment.

But the strike has ended, as has the cold and stormy weather, inviting at least a partial reversal of their depressing effects in coming months. On this basis, the current quarter could easily witness a surge in sales of capital goods as well as a major uptick in commercial and industrial construction. There is also reason to look for relative stability in new spending on drilling equipment. To be sure, oil prices have risen only slightly, hardly enough to renew the pattern of widespread drilling and exploration that dominated much of 2013 and the first half of 2014. But there is ample reason to believe that the cutbacks of past months have already adjusted levels of activity to lower prices so that the industry no longer has need for further sharp cutbacks, certainly not of the sort suffered during the first quarter. Some of the drilling that was cancelled might even return. On these bases, the second and possibly third quarter could see a surge in spending on both equipment and construction that, except in the energy space, more or less recovers the ground lost in the first quarter.

Still, the Underlying Trends Don’t Look Good
Beneath these down/up gyrations, the fundamentals look weak, if not in outright decline. Orders for non-defense capital goods, including or excluding the volatile aircraft sector, show decreases over the last 12 months. The former fell 2.6%, while the latter fell 1.8%. These data are only available in nominal terms. When combined with the Commerce Department’s 1.1% inflation estimate for the sector, a real measure of these orders would, respectively, approach declines of 3.7% for overall non-defense capital goods orders and 2.9% when aircraft is excluded. To be sure, sales have held up during the past year, despite the orders decline. In real terms, sales of non-defense capital goods have risen an estimated 3.6% during the past 12 months, 1.6% after removing aircraft from the equation. But the sales are done, while the orders reflect on the future. It is doubtful that sales will follow orders down point for point, but the outlook is clearly soft.       

It is also less than encouraging that capital spending was slowing even before the special depressing effects of the year’s first quarter. The rate of expansion in real overall spending by business on equipment, premises, and intellectual capital actually peaked as long ago as the fourth quarter of 2013 at an annual growth pace of 10.4%. It slowed to an average 7.1% annual growth rate during the first three quarters of 2014 and then slowed further to a 4.7% annual rate of gain in the fourth quarter, well before the first quarter distortions. The subsectors of structures and equipment spending followed the same slowing pattern, with growth in equipment spending all but stopping during last year’s fourth quarter, growing at only a 0.6% annual rate, before slowing even further to a negligible 0.1% rate of advance under the first quarter’s transitory constraints.

The only exception—and indeed, one bright spot—are patterns of spending on intellectual products, most notably research and development (R&D). Overall, such spending gained momentum throughout 2014, rising from a relatively slow 3.6% real annual growth rate at the end of 2013 to a 10.3% real annual rate of advance by the end of 2014. Even under the special retardants of the quarter just passed, this kind of spending continued to grow at the real 7.8% annual pace quoted earlier. This pattern was even more exaggerated in the R&D subcategory. It rose from a 3.6% real annual growth pace at the close of 2013 to a 17.2% rate at the end of 2014, sustaining a 12.3% annual rate of expansion even during the first quarter’s constrained environment.

Broader Implications   
This middling underlying picture, apart from R&D, is not, however, so weak that it threatens an outright decline. It is, consequently, not likely to derail the recovery. Instead, it makes one more argument to expect the historically slow pace of overall economic growth to continue going forward. This prospect may not offer much inspiration, but it is hardly shocking, nor should it be. It is, after all, the sort of recovery to which everyone has grown familiar with during the past five-plus years. In time, as political matters clarify and the adverse legacy of the Great Recession wears off, the pace of growth, including in capital spending, may well pick up, but the data to date suggest that such a time is still relatively distant.

There is a still longer-term concern that requires attention. Weak business spending on equipment and premises says little good about future rates of productivity growth. Fewer relationships are better linked than the positive influence of capital spending on productivity. Not only does such spending give workers more support, and so tends to enhance labor productivity, but by bringing new techniques and technologies into production processes—or, as economists say, embodied in the new equipment and facilities—the capital spending also produces an acceleration in what economists call total factor productivity, that is, the output from labor, land, and capital combined. The most recent evidence comes from the tremendous surge in capital spending that took place in the 1990s, largely in response to the technological revolution. After a time lag, during which business integrated the new technologies into its practices and processes, productivity surged in the early years of this century. Labor output per hour, for example, jumped from 1.7–1.8% annual rates of increase in the mid-to-late 1990s to more than 3.0% annual rates of increase, on average, between 2000 and 2005.2

Today’s substandard rates of capital spending suggest, then, slow productivity growth going forward, perhaps no better than the 1.5% annual growth rate for labor productivity averaged during the past five years. Even the one bright spot in today’s picture, rapid growth in R&D spending, can only offer so much encouragement. Unless the results of all the research and development inspires other sorts of capital spending, it will take a long while to filter into business practice and procedure and, accordingly, into an improved productivity picture. The hope then is that the R&D inspires spending on the new equipment and premises that can bring it into business and manufacturing practice. If recent figures are any indication, that prospect will remain a hope, not an expectation, for a while to come.

 

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