Moreover, the Fed chief was unusually clear in his semiannual testimony on monetary policy on July 20. He said that, in order to realize the Fed's upbeat forecast for sustained growth and contained inflation, "this outcome will require the Federal Reserve to continue to remove monetary accommodation." That's Fedspeak for "we're not finished yet."
Some in the financial markets may be coming around to the reality that the Fed's target federal funds rate is going to end 2005 higher than they thought earlier in the year. Just within the past three weeks, the yield on the benchmark 10-year Treasury note has jumped from a low of 3.9% on June 27 to 4.16% on July 20. Plus, the December futures contract on the federal funds rate now suggests the Fed's target will end the year at about 4%. That would imply at least three more quarter-point hikes between now and then.
But will three hikes be enough? The growing risk is that the economy is still running a little too warm for the Fed's comfort. As the economy heads into the second half, overall demand by consumers and businesses remains strongly supported by healthy income growth -- in terms of both profits and labor income -- and by rising wealth, given that the balance sheets of both the household and corporate sectors have never been in better shape. But at the heart of this support are the very easy financial conditions that flow directly from the Fed's past and current generosity on interest rates.IN PARTICULAR, REAL INTEREST RATES -- market rates adjusted for inflation -- remain low, especially real long-term rates, which are stimulative to housing, business borrowing, and many asset prices. In a July 11 response to questions from Representative James Saxton (R-N.J.) regarding his June testimony before Saxton's Joint Economic Committee, Greenspan said at least part of the decline in long-term rates in the past year appears to reflect lower real rates, a point he reiterated on July 20. Until long-term rates in the markets respond more decisively to the Fed's hikes in short-term rates, the Fed may have more work to do than the markets now expect.
With low rates helping to bolster demand, it's easy to see why second-half prospects look bright. For example, look at the ease with which the economy is weathering the energy shock. According to Greenspan, Fed staffers have estimated the increase in oil prices since the end of 2003 to have shaved about 0.5 percentage point from economic growth in 2004, and they appear on a track to restrain growth in 2005 by about 0.75 point.Considering the economy still grew 3.9% last year -- and it has a good shot at repeating that performance this year -- it's clear the economy's underlying momentum is strong. In fact, the runup in oil prices may well have done the Fed a service. If the price of a barrel of oil had remained in the $30 range, the economy would probably be sizzling right now, with the Fed scrambling to cool it down.
As it is, the Fed's latest forecast, put forth in its Monetary Policy Report to the Congress on July 20, projects that the economy will grow 3.5% in 2005 and in the range of 3.25 to 3.5% in 2006. The forecast for 2005 is slightly below the 3.75%-to-4% range projected in the Fed's February report. Inflation, on the other hand, is now expected to be in a range that is a quarter-point higher than in the February report, with unemployment a quarter-point lower.
The Fed's forecast may well offer a glimpse into its thinking on future policy. The projections imply that the Fed believes both inflation and the unemployment rate will be stable next year, as long as the economy grows in the 3.25-to-3.5% range. So growth any hotter than that will most likely be outside the Fed's comfort zone.THAT MIGHT ALREADY BE TRUE for the second half of this year, given new signs of the economy's strength. Perhaps the most important is the rebound in the industrial sector. Manufacturing had been at the center of this spring's soft spot. Business inventories had ballooned, particularly in the auto industry, and efforts to pare them resulted in weaker ordering, production, and payrolls in the factory sector. Not anymore.
A wide range of industrial data -- notably the June purchasing managers survey and June report on industrial production, in addition to some regional surveys in early July -- show a turn for the better. Industrial output jumped 0.9% in June, pumped up by a big gain in utility production. But output in the manufacturing sector alone still increased 0.4%, matching the May advance. Those gains followed 0.2% declines in both March and April.
What's happening? Robust demand, combined with the spring output cuts, has brought inventories under control. The latest monthly inventory numbers show sharply diminished growth in stockpiles in the second quarter. With stocks lean, manufacturing output is now free to resume its upward climb, clearing the way for the factory sector to add to the economy's momentum in the third quarter.MEANWHILE, HOUSEHOLDS don't appear to have lost any forward thrust. Despite the stress from record gas prices, consumers pounced on Detroit's June round of sales incentives, helping to push overall retail sales for the month up by a booming 1.7%. For the quarter, sales grew at an annual rate of 10.7%, the best quarterly showing in a year and a half. In fact, consumer spending, as it will be tallied in the GDP numbers due out on July 29, may well have grown faster in the second quarter than its healthy 3.6% rate in the first quarter.Plus, with mortgage rates lower now than they were when the Fed began lifting short-term rates, housing demand has barely cooled. Builders broke ground on 2 million new homes in June, the same as in May. The backlog of housing projects is growing: June permits authorizing construction on single-family homes, most of which were started that same month, rose to the highest level of the year.
But an increasing number of those permits are gathering dust, waiting for builders to finish existing projects. The number of permits authorizing construction that has not yet begun rose to a record 177,000 in June. In the past year and a half this backlog has soared 68%, and 35% in only the past four months. That suggests a high level of construction activity through the summer.
The housing sector represents a microcosm of the task facing the Fed. As long as the real cost of borrowing remains as cheap as it is, low interest rates will continue to stimulate the economy -- perhaps more than the Fed would desire, which could force more rate hikes. By James C. Cooper & Kathleen Madigan