A Golden Age Of Steady Growth?

It's a beguiling--and risky--notion

Is the U.S. business cycle defunct? Has the economy, in the words of Paul A. McCulley of UBS Securities Inc., "entered a golden age in which growth modulates endlessly between soft landings and soft takeoffs?"

Judging by the stock market this year, many investors believe in a brave new world of continued growth, low unemployment, and moderate inflation. And their strongest argument is the expansion itself, which is entering its seventh year with nary a twitch in the inflation indicators despite a low jobless rate.

Surprisingly, the Federal Reserve is not the major factor behind this development, observes John H. Makin of the American Enterprise Institute. Rather, it is the inflation-wary bond market, which has responded to growth surges by pushing up interest rates--and to slackening growth by lowering them.

Because long-term rates affect such key sectors as housing and autos, these shifts have acted as an automatic stabilizer. As DRI/McGraw-Hill notes, much of the variation in economic activity over the past four years can be traced to their influence--with each rise and fall in rates causing an almost symmetrical slowdown or acceleration in growth after a year's time (chart).

The self-regulating pattern of bond rates is one reason the Fed hasn't felt the need to touch the monetary tiller in the past year, says Makin. Another is the rising dollar, which provides added insurance against inflationary pressures. Indeed, it is the idealized view of a robust but inflation-free U.S. economy that has added to the dollar's appeal in recent months, just as it has fueled the latest surge in stock prices.

The problem, says Makin, is that belief in the arrival of a golden age may contain the seeds of its own destruction. McCulley of UBS Securities, for one, sees signs that it is causing bond markets to become complacent about inflation risks. And Makin argues that it leaves increasingly bullish stock market investors psychologically unprepared for economic shocks that lie ahead.

"The delicate task now facing the Fed," he says, "is to remind investors that the golden-age scenario cannot last forever, without causing them to panic."

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