Ever since it became clear that the U.S. economy had powered ahead at a torrid 7% annual rate late last year, investors have worried that accelerating growth would unleash inflation. When the Federal Reserve Board raised short-term interest rates on Feb. 4, investors bailed out of bonds, fearing that the Fed had early warnings of an imminent inflation surge.
Forget inflation. The bond market's plunge is a vivid demonstration that the U.S. economy can't generate a sustained price acceleration. Together, inflation hawks at the Fed and vigilantes in the bond market will react to even a hint of price pressure, pushing interest rates high enough to modulate growth. That, in turn, will ease inflation pressures. "The bond market and the Fed are both a little on the crazy side, and rising rates dramatically increase the odds that inflation can't go higher but will go lower," says Edward E. Yardeni, economist at C.J. Lawrence. Adds Peter Bernstein, a New York-based economist: "The rise in rates was a stern warning by the markets that any inflation will be penalized."
PLENTY OF POSITIVES. Moreover, this rate surge won't send the economy into a deep funk. For one thing, the increase in rates is unlikely to last for a long time because it's overdone. Producer and consumer price inflation for goods other than food and energy have risen less than 1% during the past year. In the global economy, industrial capacity is in excess, labor supplies are ample, and competition is white-hot. That will restrain prices and wages in the U.S. Says Christopher Turner, chief currency economist at Barclays de Zoete Wedd Ltd. in London: "As long as the U.S. market remains fairly open, competition should help keep a lid on inflation."
The U.S. economy, meanwhile, has a lot going for it, including healthy corporate balance sheets and rising consumer demand. Most important, though, is the seismic force of higher productivity. Companies can ramp up output sharply without straining capacity and provoking a wage-and-price spiral. Improved productivity means faster economic growth and low inflation can coexist.
U.S. companies are achieving stunning gains in productivity through the painful tactics of cost-cutting and layoffs. But what makes this productivity improvement special is that many companies have moved beyond the survival strategies of slash-and-burn. They are tearing down bureaucratic walls, giving more power to workers, and investing huge sums in high-tech equipment. Over the past three years, business investment has grown at a heady 10.9% average annual rate.
The payoff: Despite the slowest growth of any business upturn since World War II, output per hour in the nonfarm business sector has risen at a 2% average annual rate, similar to the trend of the 1950s to early 1970s. "Thanks to the information revolution, the U.S. economy is on a faster productivity track than it was during the previous two decades," say economists at Merrill Lynch & Co.
A REPEAT? Of course, investors are naturally reluctant to risk trillions on a theory that inflation can stay low and growth robust. But it has happened before: Take the period surrounding the turn of the century. It was a time of tremendous international capital and trade flows, strong growth, technological innovation, and negligible inflation.
If the productivity thesis is right, the economy's noninflationary growth potential is sharply higher than it was in the 1970s and 1980s. Bond rates will trend lower, and the stock market will head higher. Despite violent spikes in interest rates, the economy will grow faster, and living standards will rise. That's good for Main Street as well as Wall Street.