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The Business Situation, August 1986 the Business Situation August 1986 REVISED (45-day) estimates show that real GNP increased at an annual rate of 1/2 percent in the second quarter of 1986; preliminary (15-day) estimates had shown a 1-percent increase (table 1). The downward revision was more than accounted by inventory investment and net exports; personal consumption expenditures and Federal Government purchases of goods and services were revised up. Revisions in other components of GNP were small. The GNP price index (fixed weights) was essentially unrevised at a 2-percent annual rate of increase./1/ _____________________________________________________________________________ 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 annualized. Real, or constant-dollar, estimates are expressed in 1982 dollars. _____________________________________________________________________________ Generally, the revisions reinforce the changes in individual components reported in the preliminary estimates. Inventory investment and net exports, which had declined according to the preliminary estimates, declined more in the revised estimates. Personal consumption expenditures and Federal Government purchases, which had increased, increased more. Overall, the revisions do not alter the picture of sharp, largely offsetting changes in several components of GNP that was presented in the July "Business Situation." Corporate profits Profits from current production--profits before tax with inventory valuation adjustment (IVA) and capital consumption adjustment (CCAdj)-- declined $5 billion in the second quarter, following an $11 billion increase in the first. Domestic profits of nonfinancial corporations declined $7 billion, following an increase of $2 billion, reflecting declines both in real gross corporate product and in profits per unit of product. The decline in unit profits resulted from a larger increase in unit labor cost than in unit price; unit nonlabor costs were unchanged. Domestic profits of financial corporations increased $3 billion, following an increase of $5 1/2 billion, and profits from the rest of the world declined $1 billion, following an increase of $3 1/2 billion. Profits before tax.--Profits before tax (PBT) increased $7 1/2 billion in the second quarter, following a decline of $11 1/2 billion in the first. The contrast between the increase in PBT and the decline in profits from current production is due to the CCAdj, which declined $4 billion, and to the IVA, which declined $8 1/2 billion. Both of these adjustments are reflected in the current production measure but not in PBT. The CCAdj is the difference between depreciation based (like PBT) largely on tax accounting, on the one hand, and economic depreciation as defined by BEA, on the other. In the second quarter, as in the first, tax-based depreciation declined slightly while economic depreciation continued to increase; as a result, the CCAdj declined. The decline in tax-based depreciation reflected the provisions of the Economic Recovery Tax Act of 1981, under which new assets are depreciated in 1986 at a lower rate than 5-year-old assets that drop out of the depreciation base. The IVA removes the capital-gains-like element from profits based on tax accounting when inventory prices increase; likewise, it removes the capital-loss-like element when inventory prices decline. In the second quarter, the IVA was positive--indicating losses--but smaller than in the first, as overall inventory prices continued to decline but by less than in the first. In manufacturing, inventory prices dropped more than in the first quarter, while in trade, inventory prices generally increased after declining in the first quarter. Profits with IVA but without CCAdj.--The quarterly measure of profits available by industry declined $1 billion, following an increase of $14 1/2 billion. A $3 billion decline in the profits of nonfinancial corporations was more than accounted for by trade; profits in manufacturing and in transportation and public utilities increased. In both wholesale and retail trade, the increases in inventory prices mentioned above contributed to drops in profits. In retail trade, the drop was intensified by declines in the prices of goods sold. Manufacturing profits increased after two quarters of decline. The increase was concentrated in durables manufacturing, especially electric and nonelectric machinery. In nondurables, petroleum profits increased but the increase represented only a partial rebound from a very low first-quarter level that reflected the payment of a large fine to the U.S. Department of Energy by a major corporation; in the absence of the fine, profits would have declined in both quarters, reflecting the path of petroleum prices. In transportation and public utilities, lower petroleum prices contributed to increased profits. Government sector The fiscal position of the government sector in the national income and product accounts deteriorated considerably in the second quarter of 1986, as the combined deficit of the Federal Government and of State and local governments increased $45 1/2 billion (table 2). The deterioration was the result of an increase in the Federal deficit and a decrease in the State and local surplus. The Federal Sector.--The Federal Government deficit increased $35 1/2 billion in the second quarter to $237 billion, as expenditures increased more than receipts. Receipts increased $6 billion after a decline of the same amount in the first quarter, when only contributions for social insurance increased. In the second quarter, indirect business tax and nontax accruals continued to decline, and all other categories of receipts increased. In recent quarters, the movement of indirect business taxes has been influenced by a rather steady decline, reflecting crude oil prices, in windfall profit taxes. The windfall profit tax was enacted in April 1980 as a temporary excise tax on domestically produced crude oil. Receipts from this tax reached a peak of $26 1/2 billion in the second quarter of 1981; these receipts were only $0.1 billion in the second quarter of 1986. Expenditures increased $41 billion after a decline of $22 billion in the first quarter. Over two-thirds of this swing was accounted for by the effect of farm programs operated by the Commodity Credit Corporation (CCC) on nondefense purchases of goods and services and on subsidies less the current surplus of government enterprises. Nondefense purchases were essentially unchanged after a $23 1/2 billion decline in the first quarter. The purchases of agricultural commodities by the CCC accounted for almost all of the first-quarter decline, and they were unchanged at $5 1/2 billion in the second. Subsidies less the current surplus increased $18 1/2 billion after a $3 billion decline in the first quarter; the swing was due to the CCC. The CCC deficit, which had declined $3 billion in the first quarter, declined only $1/2 billion in the second. Agricultural subsidies accounted for the remainder of the change in farm programs; these subsidies increased $19 billion in the second quarter--mainly for advance deficiency payments--after no change in the first. The advance deficiency payments amounted to over $15 billion and were paid in two forms--cash ($11 billion) and payment-in-kind (PIK) certificates ($4 billion). The cash payments were made to producers of feed grains ($6 1/2 billion), wheat ($2 1/2 billion), upland cotton ($1 1/2 billion), and rice (over $1/2 billion). The PIK certificates are generic; that is, they can be redeemed at face value for any commodity. The certificates can also be sold--to other farmers or to, for example, grain storage operators--or they can be redeemed for cash from the CCC beginning October 1. If they are redeemed for cash, the CCC will discount the value of the certificates by 4.3 percent under the Gramm-Rudman deficit-reduction requirements. In addition, $1 billion of advance diversion payments were also paid in the form of certificates. (See "Federal Farm Programs for 1986-90" in the April 1986 SURVEY for the definitions of these payments.) Although programs of the CCC accounted far the bulk of the swing in expenditures, there were also swings from decline to increase in national defense purchases of goods and services and in transfer payments to foreigners. National defense purchases increased $11 1/2 billion after a $1 1/2 billion decline in the first quarter. The increase was concentrated in military hardware--especially aircraft and missiles, which included the delivery of two additional B-1 bombers and the first two MX missiles--and in research and development. The only major decline--over $2 billion--was for purchases of petroleum products, reflecting declining prices. Transfer payments to foreigners increased $2 1/2 billion after a $5 billion decline in the first quarter. The first-quarter decline was the result of a fourth-quarter payment of the entire amount of the fiscal year 1986 economic assistance to Israel. The second-quarter increase was in both military and economic assistance. Among other expenditures, grants-in-aid to State and local governments increased $3 1/2 billion. The increase was accounted for by payments to five States for settlement of a dispute between the Federal and State governments over revenue from leases of the Outer Continental Shelf and from royalties paid on discovered oil. The largest payments--$1 1/2 billion each--were to Texas and California. 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 $214 billion in the first quarter to a deficit of $244 billion in the second (see table 2). The cyclically adjusted deficit as a percentage of middle-expansion trend GNP increased from 5.2 percent in the first quarter to 5.9 percent in the second. The State and local sector.--The State and local government surplus declined $10 billion in the second quarter to $60 billion, as expenditures increased more than receipts. A decline in the surplus of other than social insurance funds more than accounted for the total decline. Receipts increased $3 billion, compared with $15 1/2 billion in the first quarter, when receipts were boosted by the payment of a fine ($8 billion at an annual rate) by a major petroleum corporation as a result of a Supreme Court ruling on pricing violations. Excluding the effects of this fine, receipts increased $11 billion in the second quarter compared with $7 1/2 billion in the first; the acceleration was due to Federal grants-in-aid and corporate profits tax accruals. Expenditures increased $13 billion, compared with $8 billion in the first quarter. The acceleration was largely in purchases of goods and services; they increased $12 billion in the second quarter, compared with $6 billion in the first. The stronger pace of purchases was largely in purchases of structures; highway construction increased $5 1/2 billion after declining $2 billion in the first quarter. Among other types of purchases, a $2 billion decline in nondurable goods was offset by increases in durable goods and services. The decline in nondurable goods was more than accounted for by a drop in purchases of petroleum products, reflecting declining prices. Inventory-Sales Ratios Inventory-sales ratios are often analyzed to help predict inventory behavior. If a ratio is "low", it may suggest the need to rebuild inventories; if it is "high," it may suggest the need to liquidate inventories. In recent years, rapid growth of imports and large transactions of the Commodity Credit Corporation (CCC) have been suspected of reducing the predictive value of the aggregate ratios calculated within the national income and product account (NIPA) framework. The following discussion compares one of these ratios--the constant-dollar ratio of business inventories to business final sales--with two variants of it to examine whether the usefulness of the ratio has been reduced. The import-adjusted variant The first variant, as indicated in line 10 of table 3, is derived by adding imports of merchandise and nonfactor services to business final sales, the denominator of the published ratio. (Imports of factor services--that is, of labor and property--are not added, consistent with the general exclusion of nonbusiness factor services from the denominator.) The rationale for this modification follows from an implicit assumption--necessary because of data limitations--about imports in the denominator. Data are not available to split imports between final sales and inventories, and the implicit assumption is made that all imports are final sales to consumers, businesses, or governments in the quarter in which they take place. The assumption is apparent in that, in deriving GNP--a measure of U.S. produced goods and services--as the sum of final sales and change in business inventories, all imports are deducted from final sales. In reality, however, some imports go into inventories and not into final sales in the quarter of import. (The numerator, in fact, includes inventories of imported goods.) To the extent that imports go into inventories in the quarter of import, final sales of GNP and business final sales, which is derived from final sales of GNP, are understated. On the other hand, when imports are added back into the denominator, on the assumption that all imports go into inventories, business final sales are probably overstated. The ratio and the import-adjusted variant therefore provide--with respect to treatment of imports--upper and lower estimates, respectively, of the "true" ratio. The import-adjusted variant lies below the published ratio, reflecting the larger denominator of the variant. From the first quarter of 1972 to the second quarter of 1986, the variant and the ratio registered generally similar quarter-to-quarter changes. The differences in movement were as much as 0.04 in only two quarters. The ratio and the variant moved in opposite directions in only three isolated quarters, and even in these instances, the differences in movement were small. During the economic expansion from the third quarter of 1982, the ratio and the variant registered quite similar changes except in the fourth quarter of 1982, when the ratio fell more sharply than the variant, and in the first quarter of 1985, when the ratio fell and the variant increased. These two quarters are the only quarters in the expansion when imports of merchandise and nonfactor services declined. However, the ratio and the variant slowly drifted further apart: From its peak in the third quarter of 1982 to the second quarter of 1986, the ratio dropped from 3.54 to 3.24, while the variant declined slightly more--from 3.17 to 2.82. A strong increase in imports gave rise to this slow drift; constant-dollar imports of merchandise and nonfactor services increased at an annual rate of over 12 percent. Because the ratio and the variant represent the upper and lower estimates of the "true" ratio with respect to the effect of imports, this slow drift may suggest a slight increase in uncertainty about the level of the true ratio. Nevertheless, in the historical context, both the ratio and the variant yield similar insights into the likely course of inventory investment. For example, for the period shown in chart 1, both the ratio and the variant reached their lowest levels in the fourth quarter of 1985. Prior to that, both had been declining for several quarters and were at levels that appear low by historical standards. Thus, to the extent that such low levels presage increases in inventories, both would have provided the same signal as of that quarter. The slight increases in the ratio and the variant since then, although smaller for the variant, would not have clearly changed that signal. The CCC-adjusted variant The second variant, as indicated in line 11 of the table, is derived by adding the stock of inventories held by the CCC to the stock of business inventories in the numerator of the ratio and subtracting CCC inventory changes from business final sales in the denominator. The purpose of the variant is to abstract from the effect on the inventory-sales ratio of the NIPA treatment of CCC inventories, in which the CCC commodity loan program has been the major source of recent quarter-to-quarter volatility. (CCC programs and their treatment in the NIPA's were summarized in the April 1986 Survey of Current Business, pp. 34-35.) In the NIPA's, new CCC loans to farmers are recorded as Federal Government purchases in business final sales, and farmers' redemptions--which can be made at any time during the loan period--are recorded as negative purchases. Accordingly, when a crop is placed under loan, farm inventories are reduced below, and CCC inventories are increased above, what they otherwise would have been. Thus, in the quarter when a farmer places his crop under loan with CCC, economy-wide inventories are not changed but both the numerator and denominator of the inventory-sales ratio are affected--the numerator decreases, the denominator increases, and the ratio, consequently, declines. (Total CCC inventories are used in calculating both the numerator and denominator for this variant because the portion of CCC inventories not associated with the commodity loan program is relatively small and can be safely ignored for the purpose at hand.) When the two are distinguishable in the chart, the CCC-adjusted variant lies above the published ratio. From the first quarter of 1972 to the second quarter of 1986, this variant and the ratio registered generally similar quarter-to-quarter changes. The differences in movement were 0.04 or more in only two quarters. The ratio and the variant moved in opposite directions in only two isolated quarters. Both of these instances--the second quarter of 1984 and the fourth of 1985--were during the present expansion. The difference in the movement of the ratio and the variant in the fourth quarter of 1985 was the larger of the two instances of movement in the opposite direction and also the largest without regard to sign. The ratio declined from 3.23 to 3.20, while the variant increased from 3.31 to 3.34. The decline in the ratio occurred as inventories fell and final sales increased, and the increase in the variant occurred as inventories increased while final sales were flat. For CCC-adjusted inventories, the change reflected an unusually large addition to CCC inventories--$8.0 billion at a quarterly rate (or $32.3 billion at an annual rate, as shown in the addendum to table 1). For CCC-adjusted final sales, the change excluded an increase in CCC inventory change--from $1.0 billion at a monthly rate in the third quarter to $2.7 billion in the fourth (or, at an annual rate, from $11.5 billion to $32.3 billion). In both instances in which the ratio and the variant moved in opposite directions (and only in those instances), two conditions were satisfied. First, the change in CCC inventories--the adjustment to the numerator--and the change in the ratio were in opposite directions; second, the change in the change in CCC inventories--the adjustment to the denominator--was more than $15 billion (annual rate) and was in the direction opposite to the change in the ratio. More generally, if the change in the change in CCC inventories is larger than about $10 billion, then changes in the ratio and the variant are likely to be dissimilar in direction or magnitude. Although the signals sent by the ratio and variant have not been substantially different in the past, the variant may provide useful perspective when these conditions occur.