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Online Extra: What the Economic Seers Are Saying


As part of it's midyear Investment Guide, BusinessWeek's Business Outlook team of James Cooper, Kathleen Madigan, and James Mehring surveyed 34 economists on their views of the U.S. economy in the coming year. In the survey, we asked the economists to comment on four key questions that are crucial to the economic outlook. Here's a lightly edited sampling of their responses to these four questions.

1) How much and how fast do you expect the Federal Reserve to tighten in the coming year, and what factors will help or hinder the Fed's goal of engineering a soft landing?

David W. Berson, Vice-President and Chief Economist, Fannie Mae

We expect the Federal Reserve to begin tightening at the June 29-30 Federal Open Market Committee [FOMC] meeting, bringing the [Fed-controlled] federal funds rate to 2% by the end of 2004, and to around 4.50% when it is finished tightening in 2006. Continued strong productivity growth will be the major factor helping the Fed to achieve a soft landing, while higher oil prices will be the biggest factor hindering the Fed, as it will both boost inflation and slow economic growth.

William C. Dudley, Chief U.S. Economist, Goldman Sachs

We expect that Fed tightening will begin at the June 29-30 FOMC meeting and that the FOMC will tighten four times this year in 25 basis-point increments [25 basis points is one quarter of a percentage point]. So 100 basis points of tightening in all. We expect the economy to slow going forward and that this will cause the FOMC to take a break from the tightening process during the first half of 2005. Two wild cards for the Fed are energy prices and productivity growth. A rise in energy prices and/or a drop in productivity growth would worsen the growth/inflation trade-off [meaning that inflation would pickup at a slower rate of economic growth] and make it harder for Fed officials to achieve a soft landing.

Michael R. Englund, Chief Economist, Action Economics

[Fed Chairman Alan] Greenspan has shown a tendency to wait longer than the market expects to initiate a tightening cycle, and he is less willing to respond to above-trend economic growth than to excessive inflation pressure. We do not think that the Fed faces any real inflation threat, and we expect the current wave of commodity price pressure to abate in the second half of the year. The economy is strong, but growth is not yet inflationary.

Though Greenspan faces considerable pressure to tighten policy right now, we suspect that he could rhetorically evade this pressure if the employment report for May reveals evidence of wage restraint, or if other economic reports provide any indication that inflation pressure is temporary. If the Chairman can evade pressure at the June meeting, he will find 'clear sailing' through the August and September meetings when inflation will be moderating and the economy will loose some of its recent froth.

The Fed will have no problem orchestrating a soft landing at this early phase of the cycle, as we do not think that fundamentals support any meaningful inflation risk, hence leaving the Fed with substantial elbow room to take its time on slowing growth.

Stephen Gallagher, U.S. Chief Economist, Societe Generale Corporate Investment Bank

A measured pace of rate hike to me, implies a 25 basis point rate hike for nearly but not quite every FOMC meeting until the [federal] funds rate hits a neutral level of 3.5%-4.0% [a range that is believed to neither stimulate nor retard economic growth]. A danger is the market jumps ahead of the Fed, and may drag the Fed into hiking faster as fears the Fed may be falling behind the curve become a dominant view. Higher oil-induced inflation readings give greater scope to this risk scenario that could push the Fed to hike more and faster -- ultimately slowing the economy by more than desired into 2005.

Ethan Harris, Chief U.S. Economist, Lehman Brothers

The speed of Fed tightening will be mainly a function of the strength of inflation. We expect a moderate acceleration of inflation to drive a moderate rate-hike cycle. The Fed will start out slowly: the first few rate hikes will be designed to push the funds rate up in line with inflation. This allows the Fed to maintain credibility while buying time to study the economy. The Fed has three reasons for starting slowly:

(1) they want to see further healing in the labor market (2) they want to see how much of the acceleration is real and sustained and (3) that want to see how sensitive the economy is to rate hikes before hitting the brakes in earnest. We expect a 25 basis-point hike in June, with [an accompanying] statement affirming a "measured pace" [of tightening]. Then the Fed will probably skip either the August or September meeting, while hiking rates 100 basis points this year. Next year, the pace of tightening is likely to slow as the removal of monetary and fiscal stimulus causes the economy to slow.

However, if inflation heads up in earnest, and appears to be accelerating above 2.5% for the core consumer price index, [which excludes energy and food prices] then the measured pace will give way to a [much steeper] 1994-style rate cycle. We believe the inflation picture, not the job market, will be the main determinant of how aggressive the Fed is.

Lynn Reaser, Chief Economist, Banc of America Capital Management

The Federal Reserve is likely to move in quarter-point increments, with the federal funds rate reaching about 1.75% at the end of this year and 3.00% to 3.50% by yearend 2005. Factors helping the Fed to achieve a soft landing: Continued healthy productivity gains should support solid economic growth, good profit margins, and increasing real wages, while curbing the rise in unit labor costs.

Factors hindering a soft landing: Monetary policy will become less accommodative at the same time that the economy loses support from three other previous growth drivers: large tax cuts, a sharply weaker dollar, and a booming Chinese economy.

David Resler, Chief Economist, Nomura Securities International

I expect the Fed to commence tightening in June with a 25 basis-point hike. From there, I expect three more increases of 25 basis points each before the end of the year. I expect the FOMC to make a larger adjustment of 50 basis points at the first 2005 meeting in late January, followed by more rate hikes until the fed funds rate reaches 3.5% at the conclusion of the mid-year [late June] 2005 meeting. Signs of faster-than-expected core inflation (persisting and expected to stay above 2%) would accelerate the pace of tightening. Renewed signs of weakness could slow the process.

Oil prices are the wild card in the outlook. Much further increases that might trim the growth outlook by more than 0.5% could slow the tightening cycle since I suspect that oil-driven increases in inflation would be viewed as transitory.

Richard D. Rippe, Chief Economist and Managing Director, Prudential Equity Group

By the end of 2005, I expect the federal funds rate to be in the 3.0%-4.0% range. I expect the tightening to begin in June with a 25 basis point hike. Later on, several moves of 50 basis points are likely, and by the middle of 2005, the fed funds rate should be at least 150 basis points higher than today. The Fed would be helped the most by lower oil prices, the persistence of mild inflation, and the absence of major shocks.

John Ryding, Chief U.S. Economist, Bear Stearns

We believe that the Fed will seek to move the federal funds rate up -- at least initially -- in modest, quarter-point increments, starting in June and taking the funds rate to 1.75% by the end of 2004. However, we expect that this will be followed by a pickup in the pace of rate hikes in 2005, as core inflation moves above 2%, and we look for a 3.5% fed funds rate by the end of 2005.

We do not believe that gradualism is the optimal strategy for monetary policy or for the medium-term health of the bond market. The longer the Fed takes to get the fed funds rate to neutral, the higher the neutral funds rate becomes as inflation expectations rise and, consequently, the more severe the selloff in the bond market. If the Fed wants to stabilize long-term interest rates, they need to put a stop to rising inflation expectations and reduce the degree of excess liquidity more rapidly."

Mark Zandi, Chief Economist, Economy.com

The Federal Reserve will raise the federal funds rate target to 2.75% by this time next year. Inflation expectations are key to how aggressively policymakers will need to tighten policy and thus whether they are able to engineer a soft landing. As long as expectations remain tame, policymakers can pursue a measured tightening in policy."

2) Productivity, while still strong, appears to be slowing. How does the mix of slower productivity and stronger job growth affect your outlook for prices, costs, and profits?

David W. Berson, Vice-President and Chief Economist, Fannie Mae

Although it is slowing, productivity growth is still very rapid. Moreover, there is no way that it could maintain the growth rates of the past couple of years. It is unlikely to fall by enough, however, to bring price stability to an end, as long as the Fed tightens appropriately. We expect job growth of about 200,000 per month for the rest of the year, with non-farm productivity gains of about 3% for all of 2004 -- a pretty good mix."

Michael P. Carey, Vice-President & Economist, Calyon Corporate & Investment Bank

The expected cyclical slowdown in productivity growth is the flip side of a strengthening job market. The productivity advances to date have benefited owners of capital rather than labor. The situation is unlikely to be sustained as job market conditions improve. A rising labor share in the gains from productivity will reduce corporate profit margins, as firms will not be able to fully pass through the higher labor input costs. But limited pricing power is resurfacing, and some part of the higher costs will make its way into higher finished goods prices.

Stephen Gallagher, U.S. Chief Economist, Societe Generale Corporate Investment Bank

Productivity growth is faster over longer periods of time, but remains highly cyclical and a slowdown is nearly inevitable from the fast pace of 2003. A trend pace of 2.5%-2.75% productivity should prevail for a few more years, which is good news for inflation and profits. Compared to exceptional productivity growth very recently, the slowdown implies reduced profit margins, and a slowdown in currently exceptional profit growth, and faster unit labor costs.

Ethan Harris, Chief U.S. Economist, Lehman Brothers

Productivity growth is likely to slow from the 5% pace of the last two years to the 2.5% to 3% trend rate of the new economy. This will bring profit growth down in line with overall [current dollar] gross domestic product, and it will ensure continued solid job gains even as GDP growth slows next year. It will also put moderate upward pressure on business costs, although we expect most of this pressure to be felt in more normal profit growth rather than price inflation.

David Kelly, Economic Advisor, Putnam Investments

As the expansion matures, the economy's fuel mix will change with a slowdown in productivity growth and a pick up in job growth. This should cause few inflation concerns as it will occur against a backdrop of slower GDP growth overall. Unit labor costs will inevitably begin to climb however, reducing profit growth from current elevated levels to single digits over the next 12 months. However, stock prices do not appear to have fully priced in recent profit gains so the next year may see stronger gains in stock prices than in profits.

Lynn Reaser, Chief Economist, Banc of America Capital Management

Combined with slowing productivity gains, unit labor costs are likely to rise modestly. While companies will pass on some of these increases in costs, competitive pressure will tend to pare currently wide profit margins. Rising sales volumes will still support higher profits, but at a progressively more moderate pace.

David Resler, Chief Economist, Nomura Securities International

A cyclical slowdown in productivity growth, which we believe is already underway, will strengthen job growth, raise labor costs, and reduce [the growth rate of] profits as labor recaptures previous productivity gains [in the form of stronger real wage gains]. Because monetary policy will effectively constrain the growth in [current dollar] GDP, we expect only a small increase in inflation from unusually depressed levels of last year.

Richard D. Rippe, Chief Economist and Managing Director, Prudential Equity Group

I expect productivity growth to remain solid, but near 3.0%, rather than the 5-plus % of the past year. That should be enough to keep [the growth of] unit labor costs moderate (0.0% to 1.0%), and profits should keep rising with fairly low inflation.

John Ryding, Chief U.S. Economist, Bear Stearns

We expect profit growth to slow in 2004 as productivity growth slows and the labor market tightens. Nevertheless, we look for the share of profits in GDP, which has already reached the 1997 peak, to rise further into the year. We do not believe that productivity growth is a driver of inflation. It was the pressure from the low inflation environment that produced rapid productivity growth, not the other way around.

Mark Zandi, Chief Economist, Economy.com

Slower productivity growth and stronger job growth indicate that unit labor costs will soon begin to rise measurably. This will eventually weigh on profit margins and thus put increasing pressure on businesses to raise their prices more aggressively. This process should take more than a year to unfold, however.

3) The speed of the job recovery, at least through April, has been one of 2004's biggest surprises. What accounts for the sudden surge and will it continue?

William C. Dudley, Chief U.S. Economist, Goldman Sachs

Policy stimulus has been enormous, both in terms of fiscal and monetary policy. The consumer is now being weaned off the tax cuts in the sense that their size will diminish during the second half of the year and financial conditions are tightening. We think consumer spending growth will slow as a consequence, obviating the need for a very aggressive tightening episode by the Fed.

Ethan Harris, Chief U.S. Economist, Lehman Brothers

The acceleration in job growth was only a surprise in its sudden appearance. With GDP growth of 4.5% this year, even a strong productivity [driven] economy should be generating 200,000 to 300,000 jobs per month. The aberration was the weak job growth this past fall. Firms went into an extended period of hibernation in response to the many shocks to the economy -- terrorism, stock market collapse, tech wreck, governance scandal and Iraq. This negative psychological environment delayed the normal recovery in employment and capital goods spending.

More recent data show more normal growth as corporations have gotten used to a more uncertain world. We believe that the corporate sector has built up some pent-up demand for workers and machines; just as the consumer has used up his [pent-up] demand for homes and autos. Thus the job and capital-spending booms still have a long way to go.

Maury Harris, Chief U.S. Economist, UBS

In 2003, businesses put off hiring because of uncertainty about the economic recovery and perhaps because of uncertainty about world politics. Output expanded on the strength of productivity and despite reluctance to hire. But continued strong demand made new hiring even more necessary. The slowdown in investment spending [by businesses] during the last several years should result in slower productivity growth over the next several years. With rising domestic incomes and the lagged effects of the weaker dollar, demand should remain strong.

And in the absence of the extraordinary productivity gains of the past few years, demand should be met by further hiring. We expect payrolls to be added at about 180,000 per month for the remainder of the year. Also, payrolls should be revised up somewhat in the fourth quarter of 2003, if the indications from the revisions to wage and salary income in the fourth quarter of 2003 and in the first quarter of 2004 are correct; this would imply slightly more gradual improvement in payrolls than the burst of improvement now shown by the data.

Gene Huang, Chief Economist, FedEx

As the [economic] expansion broadens, and as the inventory cycle pushes up growth in the industrial sector, the requirements for both labor and capital inputs should increase. The recent surge in job creation occurred mainly in retail trade and in professional and business services. The services industry should continue to provide job growth along with output [growth]. In the meantime, the turnaround in the industrial sector should lead to job creation in the good-producing sector.

So far, we have witnessed three consecutive monthly increases in manufacturing payrolls. We expect continued support in the macro [economic] environment for a sustained job recovery.

Daniel Laufenberg, Vice-President and Chief Economist, American Express Financial

The speed of the job recovery was not a surprise to us. In fact, we were surprised when it didn't happen a bit sooner. According to the revised payroll data, it did. With the economy growing at over a 6% annual rate in the second half of 2003 and the unemployment rate declining substantially over the same period, payroll jobs were expected to follow. They typically do, and there was no reason to expect it to be different this time. So long as the economy grows at a 3.5%-4% pace on a year-ago basis, payroll job growth should remain strong. However, an average of 300,000 or more per month may be too much to expect.

Joseph Liro, Vice-President, Stone & McCarthy Research Associates

More than any other factor, the deterioration in vendor performance, or supplier delivery times, signals that companies had to start increasing employment to meet the escalating demand for goods and services. Given what we think is a sustainable productivity growth rate of 2.5%-3%, the surge in hiring should slow by late fall as companies begin to catch up with their order books.

Nicholas S. Perna, Chief Economist, Perna Associates

Part of this speedup may be "statistical" in the following sense. We couldn't fully explain why the [Labor Dept.'s] payroll survey [measure of employment] was lagging so far behind [the results of the Labor Dept.'s] household survey. Now the payroll survey is taking off!

However, there are also fundamentals at work: Businesses were overly cautious in hiring this time around and have only recently loosened up. I doubt, however, that jobs will continue to grow at the 300,000-plus pace of March and April. Something closer to 200,000 per month is more likely for the balance of 2005.

Richard D. Rippe, Chief Economist and Managing Director, Prudential Equity Group

Jobs growth will continue, but not at the pace seen in March and April. The recent pickup reflects strong GDP growth and some slowing in the rate of productivity gain.

David Wyss, Chief Economist, Standard & Poor's

Most of the employment acceleration is because the economy has surged the last three quarters. Early in the expansion, I believe employers were using contract workers rather than putting people on the full-time payroll, in order to save on fringe benefits and to avoid commitment. Now, they're confident enough to add workers full-time, and the tighter labor market is making it harder to get contract workers reliably. There will now be a period where payrolls rise while the unemployment rate remains more or less stable.

Mark Zandi, Chief Economist, Economy.com

A combination of surging corporate profits and a sharp [upward] shift in business confidence explain the sudden surge in job growth. Job growth will moderate, however, from its current heady pace and prove to be somewhat disappointing over the longer-turn.

4) With the economy growing strongly, is the slack in the economy getting used up faster than you had expected, and does that affect your inflation outlook? In particular, how does $40 oil affect your overall outlook?

Nariman Behravesh, Chief Economist, Global Insight

We have raised our core CPI [consumer price index, excluding energy and food] inflation forecast, but it is still in the low-2% region, because unit-labor-cost growth should stay below 2%, given the slack that remains in the labor market. Our forecast assumes oil prices close to $40 per barrel in the second half of the year, but falling back to near $30 in 2005. Oil prices at $40 in 2005 (rather than near $30) would lower real GDP growth by about 0.4% and raise inflation by about 0.6%."

David W. Berson, Vice-President and Chief Economist, Fannie Mae

There is still substantial slack in the economy, but rapid liquidity growth in recent years could boost inflation if the Fed does not take the excess liquidity out of the system. [Rapid liquidity growth] is already boosting world-wide commodity demand pushing up commodity prices. Oil price hikes will boost measured inflation in the short run, but as long as the Fed doesn't monetize the run-up in oil prices [by keeping the excess liquidity in the system], it shouldn't add to long run inflation.

Richard J. DeKaser, Chief Economist, National City

I differ with the conventional view that puts full employment around 4.5-5%. I think its 5-5.5%, which we should hit around yearend. With the usual 6-month lag, this should contribute to rising [labor] compensation [growth] by the second half of 2005, adding to rising unit labor costs.

Michael R. Englund, Chief Economist, Action Economics

The increasing role of the service sector of the economy makes the capacity-utilization rate less meaningful, as does the growing role of the scalable tech sector. The economy will be able to grow in excess of [traditional macroeconomic] model projections for several years running [with generating significant inflation].

Regarding oil prices, we do not see the run-up to $40 per barrel oil as reflecting any kind of supply bottleneck. The dollar has depreciated, and on a global scale the price of oil is not particularly high. On an inflation-adjusted basis, oil would need to reach $90 per barrel to reach the heights of the oil embargo days, and even then oil imports play a diminished role in our current economy.

Stephen Gallagher, U.S. Chief Economist, Societe Generale Corporate Investment Bank

Because of the strong reluctance to hire and invest, there are short-term capacity constraints that are feeding pricing power. Low inventories and just-in-time production strategies are fueling pricing powers. Many companies, after 2-3 years of failed price increases are succeeding in passing through price increases and dormant forces have been unleashed. These may prove temporary. New investment and hirers will bring slack resources on line again, reduce delivery times, and restore competitive pricing forces.

Oil prices are a risk to this generally low inflation outlook. Fed policies risk being overly accommodative to the price shock, and later this year, such fears could drive the fears that the Fed has fallen behind the curve in fighting inflation.

David Kelly, Economic Advisor, Putnam Investments

In general the unemployment rate has come down a little faster than I expected. However, labor-force participation will probably rise as people perceive better job prospects so we shouldn't see serious labor shortages. $40 oil increases measured inflation in 2004 but cuts it in 2005 both due to increased energy supplies pushing prices down next year, and the implicit oil "tax" this year, which will contribute to slower economic growth over the next year.

Jim Meil, Chief Economist, Eaton

Yes, we have bumped up our inflation outlook moderately for 2004, but [we] figured that between our anticipated moderate fallback in energy and other commodity prices next year in conjunction with Fed tightening, the inflation concern will be taken care of before it takes root.

Lynn Reaser, Chief Economist, Banc of America Capital Management

Economic slack does not appear to be dwindling faster than we had expected, but oil prices have persisted at higher levels than anticipated. The rise in oil prices has pushed up the overall inflation numbers so far this year, but the feed-through in the general price structure appears to have been limited. The persistence of $40 per barrel oil would tend to dampen real economic growth and limit the potential pressure on the economy's overall capacity.

John Ryding, Chief U.S. Economist, Bear Stearns

We do not put any stock in the output-gap model of inflation [which theorizes that inflation can pick up only when the economy reaches full employment]. We believe that inflation is a monetary phenomenon and that monetary policy works with long and variable lags. The current low core inflation environment is a product of past monetary restraint. We have already seen a significant pickup in core inflation rates and we think that the current super-accommodative 1% fed funds rate environment threatens higher inflation ahead.

Sung Won Sohn, Chief Economist, Wells Fargo

Our inflation outlook has risen in response to the rise in energy and commodity prices, and the increasing ability of some industries to pass along their cost increases as higher prices. However, our forecasts still call for historically low inflation rates year-over-year longer-term, even with the uptick in prices recently. We think that given the state of demand, productivity, and slack in capacity utilization there is little scope for a sustained period of ever rising prices.

In fact, the more likely course is a deceleration in the price increases we have seen as Iraqis violence fades, and as global supply catches up with the unanticipated jump in demand. Rising global interest rates will play an integral part in our inflation outlook, keeping a lid on demand as supplies recover.


Steve Ballmer, Power Forward
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