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Not Much Can Stop This Elevator


The U.S. economy will face a tough test in the coming year, and investors in everything from stocks to bonds to real estate have a huge stake in the outcome. Now that the recovery is no longer jobless and pricing power is returning to Corporate America, the Federal Reserve is about to begin a series of interest-rate hikes to remove unneeded monetary stimulus in order to keep inflation in check. Financial markets around the globe will be watching closely.

With the Fed back in the game, markets are bound to be more volatile. However, the betting right now is that policymakers will be able to bring the economy down for a soft landing without higher rates killing off the recovery. Despite recent upticks in some of the price indexes, inflation is expected to remain under control, allowing the Fed to lift rates gradually. Plus, the economy has plenty of momentum. Jobs are coming back strong, bolstering the outlook for consumer spending. Businesses, buoyed by new optimism and strong profits, are set to increase their outlays for inventories and equipment. And global growth is picking up, lifting prospects for U.S. exports.

Those are the key conclusions of BusinessWeek's panel of 34 forecasters surveyed as part of our midyear Economic Outlook survey. The forecasters believe the Fed will begin lifting the federal funds rate, now at 1%, at its June 29-30 meeting and continue raising it slowly to about 2.5% by this time next year. Many forecasters expect the funds rate to hit the 3% to 4% range by the end of 2005. The yield on 10-year Treasury bonds is projected to rise from 4.7% now to 5.3% by mid-2005.

The panel expects solid, if slightly slower, growth with no spike in inflation. Growth in real gross domestic product will average 3.8% for the year ending in June, 2005. That's down from 5.2% expected for the year ending in mid-2004. The yearly gain in the consumer price index will be 2.2% next spring, down from the current rate of 3.1% but up from 1.9% for all of 2003. With productivity moderating amid rising labor costs, profit gains will slip from spectacular to merely good.

A NEW DRIVER

The recovery has become fully self-sustaining, making it less vulnerable to both higher rates and unanticipated shocks. Michael P. Carey at Calyon Corporate and Investment Bank believes one reason is a reawakening of the business sector's "animal spirits," as economist John Maynard Keynes once put it, after a long period of uncertainty and cost-cutting. "Firms have been faced with a sustained period of above-trend growth in demand, and they need to increase production and hiring to meet it," says Carey.

Indeed, as of May business payrolls had recovered half of the 2.7 million jobs lost during the recession and jobless recovery. At the 238,000-per-month average pace of job growth so far this year, the shortfall will be closed by November. Better yet, high-paying factory jobs are picking up. The growth of hourly earnings of production workers has accelerated to 3% so far this year, far faster than inflation.

For the business sector, higher interest rates may not be a big constraint, since past cost restraint and current sales growth have left companies so flush they don't need to borrow much. For the first year in three decades, businesses have seen their cash flows rise above their capital-spending needs. "We believe that the corporate sector has built up some pent-up demand for machines and workers," says Ethan S. Harris at Lehman Brothers Inc. (LEH), "so the job and capital-spending booms still have a long way to go."

The return of capital spending will make the Fed's job easier. "Rising business investment in new plants and equipment and stronger exports will help the Fed by taking over from housing and consumers as the prime drivers of the expansion," says Nariman Behravesh of Global Insight Inc. The financial markets will benefit if the Fed can pursue its carefully communicated policy without worrying that GDP growth is slowing too much.

A healthy global outlook will help companies do business overseas (table). From the second quarter of 2003 to the first quarter of 2004, U.S. exports grew at the fastest pace over three quarters in 6 1/2 years. China may be trying to cool its economy, but growth there remains rapid, helping to pull along all of Asia. The Japanese economy is finally healing from within as domestic demand strengthens. In Europe, Britain is powering ahead, but progress in the 12-nation euro zone is slow, held back by Germany's struggles with high unemployment.

PRICE RESTRAINT

AMID ALL THIS economic ebullience, one crucial concern keeps cropping up: Has the Fed's long period of super-low interest rates awakened the inflation monster? If the price indexes start to breach the Fed's acceptable zone of price stability -- towards 3%, for example -- the Fed would have to hike rates more sharply than now expected, possibly inflicting real pain on the economy. That policy shift could inject a dangerous dose of uncertainty into the financial markets, and the unknown always fuels volatility on the trading floor.

Most forecasters aren't worried. "We do not think the Fed faces any real inflation threat, and we expect the recent wave of commodity price pressure to abate in the second half," says Michael R. Englund of Action Economics LLC. Commodity prices have turned down, and the economy still has considerable slack to absorb in the labor markets before any lasting price pressures can emerge. Stephen Gallagher at Soci?t? Generale Corporate Investment Bank believes that recent signs of pricing power may be the transitory result of sudden demand strength bumping up against low inventories. Corporate pricing power is likely returning to its pre-recession level. But it was not very strong then, due to global competition and strong productivity growth, forces that will keep inflation in check during the coming year.

True, productivity is slowing from its exceptional pace of more than 5% during the past year, at a time when labor costs are rising. In the past, that has been a red flag for inflation, since companies tried to push those higher costs on to their customers. But Fed Chairman Alan Greenspan believes higher costs will subtract from profits, not add to prices, as fears of losing market share will dissuade business from passing costs along. "Accordingly, the forces of competition should cap the rise in profit margins and ultimately return them to more normal levels," he said in a June 8 speech.

If Greenspan is right, earnings growth will slow, most likely to a single-digit pace from the surprisingly strong clip of 30% or more in recent quarters. That's no disaster, but it is a typical recovery pattern, which investors should already be expecting. If all works out the way the economists see it, then share prices of the companies in the Standard & Poor's 500-stock index are expected to rise by about 8% from now through the end of June, 2005.

Of course, attempts at soft landings haven't always been successful, and even victory can be brutal. The Fed's last successful effort was in 1994, but the yearlong ascent in the funds rate from 3% to 6% was a wrenching experience for the bond market, manufacturing, housing, and other rate-sensitive sectors. What are the risks this time? "Monetary policy will become less accommodative at the same time when the economy loses support from three previous growth drivers: large tax cuts, a sharply weaker dollar, and a booming Chinese economy," says Lynn Reaser at Banc of America Capital Management (BAC). Households will lose access to billions in refinancing money as mortgage rates rise, and consumers and businesses must shoulder the implicit tax burden of stubbornly high oil and gas prices. Any surprise along the way -- such as new turmoil in the Middle East or a rip in China's financial fabric -- could make the Fed's job doubly tough.

This time, with inflation already low, the Fed's chances of success are high. "The Fed would be helped the most by lower oil prices, the persistence of mild inflation, and the absence of major shocks," says Richard Rippe of Prudential Equity Group. With a little bit of luck, the result will be a stable investment climate, marked by a long period of tidy economic growth and tame inflation.

By James C. CooperWith Kathleen Madigan and James Mehring in New York


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