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|  | JULY 26, 2004
 DAVID WYSS ON THE ECONOMY By David Wyss The Economy's Summer Vacation Sure, growth has slowed slightly, but the resilient consumer and higher employment could easily jump-start activity The economy cooled off in June, with weaker consumer sales and factory orders suggesting that growth has moderated. The smaller rise in employment, although distorted by seasonal factors, also suggests that excessive growth may be less of a problem than we at Standard & Poor's -- and the Federal Reserve Bank -- had thought. Inflation has begun to edge higher, but the Fed continues to believe what it calls "transitory factors" account for much of the acceleration. The Fed raised interest rates by 25 basis points, to 1.25%, at its June 29-30 meeting. If growth continues to moderate, however, the central bank may not have to follow up as fast as we first thought. We still expect another 25 basis-point rate hike in August and an additional 50 basis points by yearend, but these hikes could be delayed if the economy softens more than we expect. That could happen as consumers, who had led this recovery, continue to run out of steam -- or at least money. This year, for the first time since 1997, growth in consumer spending is likely to trail gross domestic product growth. For the last three years, consumer spending has been supported by three factors: tax cuts, which increased household disposable income; low interest rates, which allowed cheap borrowing and cut monthly mortgage payments; and low inflation. These offset the loss of jobs in the recession and the loss of wealth in the stock market crash. SHOP 'TIL THEY DROP. Now, the pattern is reversing, with wealth and employment rising, but interest rates, inflation, and possibly tax rates on their way up. Consumers are already spending almost all their income (the saving rate was 2.2% in the first quarter), and borrowing is at a record high (116% of disposable income). However, it's perilous to underestimate the American consumer. They've surprised us throughout the recession and expansion, with spending coming back much more strongly and quickly after September 11 than we thought likely. The low saving rate would appear to be a problem, but historically, the saving rate has tended to be revised upward. More important, consumer confidence is very high, with the Conference Board survey hitting a two-year high of 101.9 in June. People consider the current economic conditions as very good, and they view the future with complacency. A short-term drop in oil prices affirmed the optimistic outlook, which will likely remain in place unless another terrorist attack occurs. The strength of the housing market also suggests the consumer will hang in. Home sales are good leading indicators for durable spending, since buying a home is often followed by the purchase of furniture, hardware, and garden items. Moreover, when consumers are sufficiently confident to spend money on a house, they're usually confident enough to buy other things, such as new cars, as well. HEALTHY HIRING. Despite the rise in mortgage rates, home sales soared in May. Such an increase is typical as interest rates begin to rise, since undecided buyers try to jump on the ship as it leaves the dock. This dynamic should keep housing strong through the buying season -- traditionally, spring through September -- thus boosting consumer spending. For 2004 both home sales and single-family housing starts are expected to beat the record set in 2003. Even after the Federal Reserve finishes its rate hikes, mortgage rates are likely to hit around 7% and stay there. That's still a low rate historically, and for many Americans, it will continue to be cheaper to buy than to rent. First-time homebuyers will stay in the market, which will continue to support furniture and appliance sales. What's more, employment growth is expected to remain strong, as productivity slackens from the tremendous pace of the last two years. Output rose 4.9% in 2002 and 4.4% in 2003. This year, it's slowing to 3.8%, which is still very strong by historical standards. We expect productivity to slow to 2.5% thereafter, which is near its average for the late 1990s. Even if the economy tails off, employment growth should remain solidly in the range of 150,000 to 200,000 new jobs per month, consistent with a slight decline in the unemployment rate from its current 5.6% level. ROUGH OIL PATCH? At S&P, we expect economic growth to reaccelerate this summer, as consumer spending snaps back and investment regains strength. The risks of a prolonged slowdown, however, are very real, and very worrisome to the President's reelection bid. However, it's worth noting that the major risks to the expansion come from abroad, not from inside the U.S. Oil prices, which could shoot higher if the Middle East turmoil worsens, remain a weak spot for the U.S. economy. Oil hovering near $40 per barrel only slightly puts a drag on the economy, but a sharper jump could slow it more. The impact of a terror attack before the election is impossible to calculate, since too many variables are involved. At S&P, we also worry that slow growth in other industrial countries and a cooling off in China could weaken U.S. exports.  Wyss is chief economist for Standard & Poor's Edited by Patricia O'Connell All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report. Standard & Poor's Regulatory Disclosure Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc.
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