| BUSINESSWEEK ONLINE : JUNE 28, 1999 ISSUE | ||||||||
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| BUSINESS OUTLOOK
U.S.: Rates Are the Question. What Is the Answer? No inflation in May, but the economy is still running flat out To hike or not to hike? That is the question. For the first time since March, 1997, the Federal Reserve is seriously considering lifting interest rates. To be sure, when the policymakers sit down around the big oval table on June 29-30, the resolve of Fed Chairman Alan Greenspan will be the key to any decision. Still, each side will bring arguments and, based on the latest economic data, each will have plenty of ammo. For the inflation hawks, the bottom line will be that monetary policy is too stimulative, based on the persistent strength in U.S. demand, especially by consumers, and that the economy shows few signs of slowing down on its own. Perhaps most important, the hawks will argue that, in retrospect, the three quarter-point rate cuts amid the financial-market turmoil last fall provided unnecessary stimulus. Also, the hawks will point to the extremely tight labor market, which was the primary factor in the May 18 shift in Fed policy from a ''neutral'' to ''tightening'' stance. Manufacturing, whose slump had taken pressure off the labor markets, now shows new strength, and firming global conditions may begin to lift now rock-bottom commodity prices. On the other side, the more dovish policymakers will argue that strong growth is not an inflation problem, as long as productivity growth is rapid enough to restrain unit labor costs, inflation's primary fuel. They will also say that, despite tight labor markets, wage growth is slowing, and the May consumer price index was very tame after April's unexpected surge (chart). Plus, given the dollar's renewed strength, nonoil import prices are falling again. And any global recovery will not quickly absorb the worldwide glut of capacity. WHO WILL PREVAIL? Until the May consumer price index (CPI) report, the hawks appeared to have the upper hand. That's because the most recent economic data show no sign that growth is cooling off. Nevertheless, the CPI did not rise at all in May, and the core index, which excludes energy and food, rose only a scant 0.1%. Those numbers strongly argue that April's 0.7% overall increase, as well as April's 0.4% jump in the core index, were flukes and not a precursor of higher inflation. Three major price categories--shelter, apparel, and medical care--were benign in May after posting surprising gains in April. The May CPI raises some doubt that a rate hike is immediately necessary. That's especially true since the producer price index also did not repeat its April uptick. Producer prices for finished goods rose just 0.2% in May, after a gas-fueled 0.5% gain in April. The core PPI has shown no growth so far this year. Still, the hawks will argue that the price indexes are backward-looking. More important, they will say, is the recent spate of reports showing that the economy continues to barrel ahead. That could mean that demand is growing so strongly that cost and price pressures will lead to higher inflation later on. Judging by the strong 1% jump in May retail sales, consumer spending continues to power overall demand in the second quarter. Adjusted for inflation, retail sales in April and May show some slowdown from the record 16% annual rate of growth in the first quarter. But with May car sales running at a 17.4 million annual pace, the strongest since an incentive-driven surge in 1986, consumers are clearly still spending at full tilt. The Fed knows that the economy will not slow down until consumers do. Also, the 6.3% rise in May housing starts suggests that homebuilding still has some oomph. Single-family starts alone surged 12.8%, to the highest level since December, 1978. In addition, mortgage applications continue to rise in June (chart), and the June survey of homebuilders showed that builders report very upbeat market conditions. The Housing Market Index, reported by the National Association of Home Builders, rose to 77 in June, from 76 in May. The index is only a shade below its record of 78, hit last November and December. If the Fed expects the bond market to do the Fed's job of slowing the economy, then housing will be key to that effort. Mortgage rates have backed up in recent weeks, propelled by the surge in bond yields that was fueled by expectations of a Fed rate hike. The yield on the 30-year bond, which touched a 19-month high of 6.17% on June 11, has since rallied somewhat, as investors believe that the bond sell-off has gone too far. That rally continued after the May CPI report, as yields fell to 6.07%. However, if the Fed does not validate the recent runup in long-term yields by raising short-term rates, then the bond market may well push yields back down to more stimulative levels. Another rate-sensitive sector, manufacturing, is actually gaining momentum. Given the solid 0.4% advance in manufacturing output in May, following a similar showing in each of the previous three months, that demand is helping to generate a recovery in U.S. manufacturing. The upturn is starting to absorb some idle U.S. capacity, although operating rates remain quite loose (chart). Moreover, strong demand has cut inventories down to skimpy levels relative to sales, especially in manufacturing. In April, the ratio of business inventories to sales stood at 1.36, only slightly above the record low, suggesting some need for additional output to rebuild stocks, particularly in the auto industry. The turnaround in the U.S. factory sector comes at the same time that the rest of the world is looking firmer. Indeed, Japan posted surprisingly strong economic growth at an annual rate of 7.9% in the first quarter, after five consecutive quarters of decline. That number may overstate the true strength, though, because of seasonal adjustment problems, but it may well be saying that Japan has bottomed out. If the Fed does decide to lift rates, then the markets will want to know what comes next. Keep an eye out for any change in the Fed's intermeeting bias, that is, its ongoing leaning about the direction of policy. If policymakers lift rates and announce that they have shifted back to neutral from the current tightening stance, then that would signal that the Fed believes that one hike will do for a while. But if it raises rates and leaves the tightening bias in place, more hikes may be ahead. Of course, all this doesn't guarantee that, after a lot of squawking, the hawks will finally get their way. There are still plenty of solid arguments to be made that the Fed can wait a bit longer. The final decision will almost certainly come down to which way Greenspan himself is leaning. But the data of late suggest that time is running out. And based on the recent change in the tone of Greenspan's public remarks, the chairman might be ready to be persuaded to pull the trigger. BY JAMES C. COOPER & KATHLEEN MADIGAN _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ BACK TO TOP |
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RELATED ITEMS U.S.: Rates Are the Question. What Is the Answer? CHART: Inflation's Back? Never Mind CHART: Another Surge in Homebuying CHART: Industry Is Awash in Extra Capacity INTERACT E-Mail to Business Week Online | |||
