BUSINESSWEEK ONLINE : JUNE 26, 2000 ISSUE

COVER STORY

Coming in for a Soft Landing
Kill inflation but keep growth? The Fed may pull it off

At the end of 1999, as forecasters peered into their crystal balls, almost no one saw the economy in 2000 quite the way it looks now: blistering 6% growth over the past three quarters, building fear of inflation, and the Federal Reserve jacking up interest rates by a total of 175 basis points by May, with possibly more hikes to come. Looking toward the second half and beyond, the outlook boils down to this: Can the Fed knock out future inflation without flooring the economy?

At midyear, forecasters are generally confident that the Fed can pull it off. They point to recent signs that the economy slowed in the second quarter, and they think the cooldown will continue in the second half. That outlook is easing fears that the Fed will have to hike rates to levels that will severely crimp economic growth, squeeze profits, and hammer stock prices.

According to a June 10 survey of 50 economists by Blue Chip Economic Indicators, analysts expect real gross domestic product growth to slow from 5.4% in the first quarter to 4.1% in the second, 3.4% in the third, and 3.2% in the fourth, with the pace in 2001 holding in the low 3s. Inflation should pick up to 3.1% by yearend, from 2.6% in 1999, but slip back to 2.6% in 2001. And the unemployment rate is expected to end next year at 4.2%, slightly above where it is now.

MANAGEABLE. Pulling this off depends critically on the behavior of inflation in the coming year and on the monetary-policy decisions aimed at containing it. Luckily, tech-driven productivity gains, global competition, and immigration will restrain labor costs, so any acceleration in inflation is likely to be only gradual--and easy for the Fed to manage. ''The task ahead for the Fed would be much more difficult if a major upturn in inflation were unfolding,'' says Richard D. Rippe of Prudential Securities.

What if the Fed's Luck Runs Out?

The consensus of economists is that the Fed will successfully engineer a gentle slowdown and that the six rate hikes already in place, plus perhaps a couple more, will stabilize inflation without triggering a recession. But what if Greenspan & Co. err? Some possibilities:

The Fed has already tightened too much. The economy weakens more than is needed. Inflation begins to slow again, but unemployment rises.
Unsure about the inflation outlook, the Fed turns the screw a few more times too many. The economy slows more than expected, investors bail out, and unemployment rises sharply.
The Fed is far behind in the fight against inflation, allowing it to break out in 2001. The Fed belatedly turns aggressive, raising the risk of a severe slowdown or outright recession. Stocks and bonds suffer. The Fed must decide between addressing liquidity problems on Wall Street vs. inflation troubles on Main Street.

However, the Fed's margin of error is razor-thin this time around. As investors are well aware, low and stable inflation is the glue that has held this long-running expansion together because it kept the Fed on the sidelines. Now, with demand bumping up against the economy's supply limits, a wrong policy call could cause serious trouble (table). For instance, equity values have played an unusually large role in demand growth in recent years. If the Fed overtightens, stock prices at such high valuations are extremely vulnerable. If it undertightens, the economy could speed up again, and inflation pressures would build further, forcing the Fed to hit the brakes even harder later on.

The Fed may well be able to swing it. ''We believe that the economy is at a turning point,'' says Bruce Steinberg of Merrill Lynch Global Securities. Many interest-sensitive sectors, such as housing and autos, have come off the boil. The stock market has cooled down, especially the tech sector, allowing some diminution in the wealth effect on spending. And while labor markets are still drum-tight, productivity gains remain strong enough to limit cost pressures--and the impetus to raise prices.

Nearly all forecasters agree that consumers are the key. In the first quarter, household spending rose 5.8% from a year ago, the fastest four-quarter gain in 16 years, accounting for 80% of overall GDP growth. Forecasters believe that the consumer slowdown has begun in the second quarter, as evidenced by weak retail sales in April and May. But reining in the spending spree will not be easy. Consumer confidence in May was near a record high, with job and income prospects still very good.

Moreover, barring a large and prolonged drop in stock prices or a collapse in home values, it will take a long time for the wealth effect to diminish. In fact, the Fed faces a catch-22: As the economy shows signs of slowing, Wall Street is rallying on the belief that further stiff rate hikes will not be needed. ''The latest loosening in financial conditions suggests that the cooling in consumer demand will be limited,'' says Robert V. DiClemente, U.S. economist at Salomon Smith Barney. The broad Wilshire 5000 stock index, the best proxy for the stock wealth effect, is up some 13% from a year ago, not far behind the 15% advance in the 12 months before that.

Business investment will be another crucial sector to watch. Heavy outlays for high-tech equipment have played a key role in the growth of the economy and productivity in recent years. And capital spending is very sensitive to slower demand growth, higher interest rates, and weaker stock prices. However, many businesses know they must invest in new technology to remain competitive in the future. Through the first quarter, there was no sign that overall outlays are slowing--and tech spending is still soaring.

Strong tech investment bodes well for productivity growth, a key factor in the inflation outlook. In the first quarter, productivity grew a rapid 3.7% from a year ago, enough to offset much of the 4.4% rise in pay and benefits. Plus, Fed Chairman Alan Greenspan said on June 13 that most of the gains in productivity growth since 1995 ''appear to be structural.'' If so, that will help to keep costs under control. The problem: Productivity may slow somewhat as output slows. And unless labor markets loosen up quickly, compensation, which already picked up in the first quarter, is more likely to speed up than to slow. Combined, those trends could exert even more upward pressure on wages and prices.

The risks in the outlook? A key concern is the possible need for a ''soft landing from below.'' Because the economy has exceeded its 3.5%-to-4% sustainable noninflationary rate for several quarters, some economists--and policymakers--think the Fed will have to slow the economy to a pace well below its speed limit to prevent price pressures from continuing to build. Goldman Sachs economists say that history suggests pulling off such a maneuver without damaging the economy could be ''mission impossible.''

The worst-case scenario: If the second-quarter slowdown is only temporary, and if inflation turns out to be more entrenched than economists now believe, the Fed would have to slam on the brakes so hard that it could severely harm the economy in 2001. Right now, though, economists and investors are putting their faith in Greenspan & Co. After all, for nine years, they have made all the right moves.

By JAMES COOPER AND KATHLEEN MADIGAN

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Coming in for a Soft Landing

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Mid Year Investment Guide

Introduction
Economic Outlook
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Asset Allocation
The Stock Market
Tech Stocks
Defensive Investing
Stocks to Avoid
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Latin American Stocks
Bonds
Commentary
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