07/01/96 A HEAT WAVE HITS THE ECONOMY

A HEAT WAVE HITS THE ECONOMY
All of a sudden, the tepid economy is really cooking
So much for slow and steady. At the end of 1995, forecasters looked into their crystal balls and saw a 1996 economy humming monotonously along at a 1.9% annual rate in each quarter. Then something happened that surprised just about everyone. Economic activity in the first quarter grew at a solid 2.3% clip and threatens to barrel through the second at 4%--with enough momentum from inventory rebuilding to blaze through the autumn.
Such an extended gallop upsets a lot of recent expectations. It raises the prospect of higher wage and price growth, for one thing, which would leave the Federal Reserve little choice but to slam on the brakes harder than anyone expected just a few weeks ago. Odds of a recession next year are still below 50%. But instead of the slogging-but-consistent expansion many had expected, the emerging economic scenario may mean a cycle of the mini-booms and -busts that can make life miserable for company executives.
``SNEAK ATTACK.'' The economy's current strength is undeniable (charts). Industrial production increased by 0.7% in both April and May. Payrolls are rising at a monthly average of 220,000 so far this year, up from 185,000 in 1995. And retail sales advanced a healthy 0.8% in May. Little wonder that the Blue Chip Economic Indicators survey of economists says that the consensus forecast now expects second-quarter GDP growth of 3.3%, a significant rise from 2.3% projected in April. The most optimistic have penciled in growth of 4% or more--far above the 2.5% rate thought to be the Fed's limit for noninflationary growth.
What happened? Until recently, many signs augured poorly for such a strong expansion. Long-term interest rates have been rising sharply since December, with the yield on 30-year U.S. treasuries up by more than a percentage point, to 7.10%. Mortgage rates are climbing, too, with the 30-year fixed rate on loans up to 8.57% in mid-June. In theory, higher borrowing costs should slow demand, especially for big-ticket items such as cars and housing.
Not this time. ``The sneak attack on [GDP] forecasts came from the strength in auto sales,'' says Michael R. Englund, chief economist at MMS International, one of the McGraw-Hill Companies. So far this quarter, sales of domestically made cars and light trucks are running equal to the sturdy 13.5 million average of the first quarter. Carmakers, though, had expected a modest sales gain this year, so they spent the winter trying to pare their inventories. The March strike at General Motors Corp. did the job quicker than Detroit had planned. Now, in a game of catch-up, auto production alone could add two percentage points to GDP growth this quarter.
Fleets of sedans and minivans only tell part of the story. Even with higher long rates and a record tax bill of $75 billion in April, consumers are buying. Retail sales excluding cars are growing faster in the second quarter than they were in the first. In May, department stores, building-material suppliers, and furniture merchants rang up big sales increases. Even the struggling apparel sector shows signs of a pulse this spring.
Americans may kvetch about economic anxiety, but the fact is that jobs and wages are up solidly this year. Confidence is high. And the stock market boom has given consumers the financial security to take on $37 billion in new debt in the first four months of 1996. At Curtiss-Ryan Honda in Shelton, Conn., sales have been ``unbelievable'' since Honda introduced financing packages in February, says general manger Ed De Marseilles: ``There are lots of people who have the means and they've just been waiting for a deal.''
Increased demand, though, has caught many businesses by surprise. General Electric Co.'s appliance division, for one, had expected a flat year industrywide. Instead, demand is up about 4% from a year ago, and GE workers are looking at a lot of overtime this summer. ``The month of May was a relative boomer and June seems equally strong,'' says Steven C. Riedel, vice-president for marketing and product management at the division. ``We feel pretty positive about the balance of the year.''
Demand from the corporate sector is also going gangbusters. Healthy profits and a surging stock market give businesses the cash to spend on more productive equipment. ``We continue to see robust growth in electronic capital goods--between 15% and 20%--which, from a historical standpoint, is quite high,'' says Vladi Catto, chief economist at Texas Instruments Inc. Output of business equipment, from low-tech gas turbines to high-tech textile looms, is up a sturdy 8% from a year ago.
The demand shock has left inventories low compared to sales. So manufacturers are gearing up production to restock warehouses while also filling new orders. Inventory rebuilding is why some economists expect a robust third quarter, with GDP growth at 3% or more.
HAWK SQUAWK. All this activity, of course, has not gone unnoticed by inflation hawks roosting in the bond market. Keep this frenzied pace up, they warn, and faster inflation will be hot on its heels. Price pressures have to be a concern, what with unemployment already at 5.6% and capacity use on the rise.
For now, though, the Fed is unlikely to raise short-term rates at its upcoming July 2-3 meeting. But expectations on Wall Street are increasing that policymakers will lift the federal funds rate, now at 5.25%, by a quarter point at the Aug. 20 meeting. And MMS's Englund for one sees another quarter-point lift in September. Fed insiders, however, say it won't worry about growth as long as inflation indicators stay in check.
The growth surge hasn't tripped any inflation circuits yet. Ruthless bargain-hunting by consumers is one reason, as are productivity gains that are keeping labor costs low. Economists expect consumer prices to increase just 3.1% for all of 1996.
Many economists now don't expect a slowdown before the fourth quarter. By then, they assume, inventory rebuilding will be done. Higher mortgage rates will have sufficiently slowed housing starts, and weaker profits will put some capital spending on hold. As for consumers, increased credit problems will curtail borrowing. Delinquency rates for credit cards hit a 15-year high in the first quarter, and households are using a record 11% of their aftertax income to pay off old installment debts.
And next year? The big danger remains that inflation fears will somehow spook the bond market. In that event, bond yields could head above 7.5%, forcing the Fed to hike rates faster than planned. Such concerns make next year's outlook dicey. At the very least, the economy's strong run this year is likely to leave it short of breath in 1997.
By Kathleen Madigan in New York, with Zachary Schiller in Cleveland, and Gary McWilliams in Houston