Filtering Out the Economic Noise


By Amey Stone Midway through the year, stocks are regaining lost ground, and long-term interest rates remain shockingly low, yet some high-profile economic reports have been jarringly bad. The May employment survey showed a paltry 78,000 new jobs created when more than 200,000 were forecast. Bloated inventories have clogged the factory sector, which was expected to be humming along nicely by now.

Especially confusing lately has been rhetoric out of the Federal Reserve. On June 1 the Dallas Federal Reserve Bank president said the central bank is in the "eighth inning" of the tightening series. Yet on June 7, the Atlanta Fed president indicated that more rate hikes were in store. So which inning are we in?

In remarks on June 6, even Fed Chairman Alan Greenspan admitted "puzzlement" over the fact that long-term rates are falling -- the 10-year Treasury is at 3.91% -- while the Fed has raised short-term rates eight times in the past year, from 1% to 3%. Greenspan will testify before Congress' Joint Economic Committee on June 9 -- and Wall Street hopes he'll hint at his rate-setting plans, soothing jittery investors.

So how can the average person know what's going on when even key policymakers seem baffled? Here are a few insights, offered in Socratic form:

Q: How is the economy performing, anyway?

A: "Solid but slowing," is how Sherry Cooper, global economic strategist at BMO Financial Group in Toronto, sums it up. Gross domestic product growth has slipped in the past three quarters from 4%, to 3.8%, to a preliminary reading of 3.5% in 2005's first quarter. Yes, the economy is slowing. But that's still decent growth. Plus, first-quarter GDP may well be revised up, and second-quarter growth should tick back to 3.8%, believes Mike Englund, chief economist at research firm Action Economics.

Many economists believe the U.S. is in the later stages of an economic cycle, where growth is sustainable but not surging the way it did in 2004. "I think the economy is following a pretty standard, if muted, cyclical course," says Milton Ezrati, senior economic strategist at Lord, Abbett. He thinks it could stay in this phase for quite a while. Cooper agrees. She doesn't expect another recession for the rest of this decade, although she forecasts GDP growth of just 2.6% for 2006.

Q: Why is the Fed raising rates if the economy is slowing?

A: The main reason is that it wants to get rates back to "neutral" -- or to the point where low rates aren't stimulating the economy but high rates aren't holding it back either, says Ezrati. Much of the debate over rate-setting policy has to do with just what this hypothetical neutral rate would be.

The Fed also has to watch out for inflation, which has been inching up lately, even as the economy has slowed. High energy prices, which economists believe may be transient, are the main reason, so Greenspan isn't too worried yet. Cooper also sees little cause for concern about serious inflation triggered by higher wages. "There is just too much global competitive pressure and too much competition for jobs," she says.

Q: Is the Fed likely to keep raising rates?

A: Most economists expect two or three more rate hikes this year. The Fed's next meeting is June 29, and another quarter-point hike is pretty much baked in the cake. The hand-wringing is over how many more times after that will the Fed move.

Investors are worried that Greenspan & Co. might go too far and raise rates so much that it triggers an economic slowdown. That's why these days stocks soar at each suggestion that the rate-tightening cycle is coming to an end, but fall at each hint of more hikes to come.

Q: If the Fed is raising rates, why are mortgage rates heading down?

A: Home loans are linked to the rate on 10-year Treasuries, which have remained stubbornly -- and surprisingly -- low this year. In recent weeks, mortgage rates have fallen well below 6%, sparking a new wave of refinancing activity and adding more fuel to a housing market that's already on fire.

Q: Why aren't long-term rates rising along with short-term rates?

A: Aye, there's the rub. There's no good explanation, but economists cite lots of reasons: heavy Treasury buying by foreign central banks, short supply of long-term debt, increasing demand from underfunded pensions, and an aging population.

Greenspan suggested in a speech in Beijing on June 7 that long-term interest rates may soon dip below short-term rates, creating a rare bond market phenomenon known as an "inverted yield curve." Normally, investors would demand to be paid higher rates for the risk of owning a longer-term bond.

Q: So does this mean a recession is around the corner?

A: No, not really. Greenspan sparked a temporary rally in stocks on June 7 when he voiced the opinion in Beijing that an inverted yield curve didn't portend a recession or an economic slowdown.

With consumer confidence gaining, retail spending remaining strong, and the housing boom continuing apace, Action Economics' Englund sees little reason for worry. Even though data on factory-level activity has been weak, he sees that as one of the only clouds in an otherwise bright picture.

Q: What about all those doomsday scenarios I keep hearing about, like a housing market collapse, crude oil at $100 a barrel, and a hedge-fund implosion?

A: Those worries haven't gone away, but they've receded into the background. Oil briefly dipped below its high of $58 a barrel to around $50, but then went back up to $54, so it's still providing a drag on consumer and business spending. Hedge funds seem to be surviving turmoil in the capital markets sparked by problems at the auto makers. The housing market is effervescent in many regions of the U.S. But with mortgage rates falling and labor markets generally improving, chances are slim that anything will drag housing down to earth in the near term.

Q: What should we be most concerned about?

A: If you want to worry, think about this: The U.S. economy is still humming along mainly thanks to the strength of consumer spending, which is being fueled by the housing boom. Business spending hasn't kept pace. Sure, Corporate America has a ton of cash, but it isn't hiring workers, expanding, and investing in the future the way it was expected to.

"Unless and until business starts hiring and spending aggressively, the best we can hope for is an anemic, real estate-fueled economy," Barry Ritholtz, chief market strategist at Maxim Group, wrote to clients on June 3.

He describes the economy as "a dog whose hunting days are coming to an end." But with some of their worst fears fading and the Fed apparently close to finished with rate-tightening, most economists are decidedly more optimistic than that -- for now, at least. Stone is a senior writer for BusinessWeek Online in New York


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