Gross investment in equipment and software has fallen so low that it is not even covering estimated depreciation, meaning that further spending increases are needed just to prevent the capital stock from continuing to shrink, let alone to foster a modest expansion of the capital stock as the recovery proceeds. So this sector has the potential to be a source of strength for the economy.

Business spending on equipment and software this year has also been firmer than I had anticipated. For example, shipments of non-defense capital goods, excluding aircraft, have increased for three straight months, and are now higher than at any point since December 2000. This category covers a large part of business equipment investment and recent reports indicate that business capital spending is holding up relatively well.

Business spending on equipment and software has also been firmer than I expected...The sense I get from our contacts is that most organizations have a large menu of options to improve and rationalize their information technology infrastructure and business processes in valuable ways, and they foresee a continual stream of spending on such projects.

Although business capital investment remained robust through the end of last year, it would not be surprising to see firms slow and perhaps even cut into this spending this year in response to overall economic softening and tighter credit conditions. This is especially true for nonresidential construction, which grew by over 15 percent in real terms last year, but now faces serious financing constraints from the credit crunch.

Investment in high-tech equipment and software was strong through the fourth quarter and this sector looks set for growth in the months ahead. But there are some signs of slowing, as orders have fallen off, and there are indications that the demand for computers is softening.

It is anticipated that investment spending should receive some help in the second half of this year from the accelerated depreciation provisions in the fiscal stimulus bill; however, based on experience with a similar tax provision in 2002 and 2003, the magnitude and timing of these effects is very uncertain.

[A]fter growing robustly through much of 2007, nonresidential construction is likely to decelerate sharply in coming quarters as business activity slows and funding becomes harder to obtain, especially for more speculative projects.    

In the business sector, balance sheets are in good shape, and most firms are not likely to face an appreciable tightening of credit availability.  As a result, I anticipate that they will expand their investment spending to keep pace with rising household demands and with strength in export markets.  In sum, once we get through the near-term weakness caused by the extra downleg from the housing contraction and any spillover from tighter credit conditions, I am looking for moderate growth with high levels of employment.

Business investment is another area I'm monitoring. At present, however, troubles in credit markets do not appear to have restricted nonfinancial businesses' access to credit. But I'm listening to business contacts for indications they are getting more cautious with spending and hiring plans.

In the second quarter, however, demand for these other types of equipment bounced back strongly, and the gains were extended in July--as reported in the most recent data on orders and shipments of capital goods.  

We have no direct readings on capital spending in August, but the limited indicators currently in hand--such as the Institute for Supply Management’s survey of purchasing managers--have held up reasonably well and remain at levels consistent with modest growth in manufacturing production and business investment. 

[R]ecent data on manufacturing output and on orders and shipments for core capital goods have been upbeat, and business investment in equipment and software promises to be a bright spot. Despite the hike in borrowing costs for higher-risk corporate borrowers and the illiquidity in markets for CLOs, it appears that financing for capital spending for most firms remains readily available on terms that have been little affected by the recent financial turmoil. Of course, the outlook for capital spending could worsen if business confidence were shaken by turbulence in global financial markets.

Business investment faltered late last year, with weaker sales of autos and construction materials apparently playing important roles. Most of the fundamentals for business investment are still quite positive, however; profitability is high and the cost of capital is still fairly low, despite recent financial market developments. Thus investment could well maintain momentum this year, I believe, and we have been seeing some favorable signs.

Like consumption spending, business fixed investment overall seems poised to rise at a moderate pace, bolstered by gains in sales and generally favorable financial conditions. 

Data on new orders and shipments of manufactured goods have shown modest improvement in recent months, suggesting a bounce back in manufacturing and business investment in the second quarter.

 Still, incoming data support prospects for an improvement in investment.  Orders and shipments of nondefense capital goods excluding aircraft rose in April for a second month.  In addition, business sentiment--as measured, for example, by the Institute for Supply Management survey of purchasing managers--has moved higher lately. 

The second development, unfortunately, is evidence of sluggishness in a new area—business investment in equipment, and, in particular, equipment outside of the reasonably strong high-tech area. The performance in non-high-tech equipment over the past nine months or so is surprising, since the business environment is marked by high profits, relatively favorable financing conditions, and growth in business output.

Part of the explanation for this sluggishness reflects what’s happening in construction—given the slump in housing, it should come as no surprise that investment in construction-related equipment has fallen off. However, even if we ignore this category, business investment has still been weak.

One commonly heard explanation is “caution in the boardroom,” as companies have felt the shocks of corporate scandals, terrorist attacks, war, and surging oil prices. While there may be some truth to this explanation, it does seem to fly in the face of the rapid growth we’ve seen in employment, which—given the cost and disruption of hiring and then having to lay off workers—also should be restrained by caution about the future.

Another explanation for weak business equipment investment that may be more likely and that is a bit more troubling is the possibility that the trend rate of productivity growth has slowed from its very fast pace over the last five years or so. For 2000-2005, the estimated trend rate was a blazing 3 percent, but for 2006, the actual data on productivity growth came in at a rate of only 1-1/2 percent. Discerning the extent to which these new lower numbers reflect a short-lived, cyclical phenomenon, a downshift in the trend rate or both, is neither obvious nor straightforward.