A Full Head Of Steam Is Choking The Bond Market

Wow! The U.S. economy grew at a blistering 7.5% annual pace in the fourth quarter of last year, the best showing in nearly a decade.

The Commerce Dept. had said earlier that real gross domestic product had posted an already solid 5.9% gain last quarter. The revision was the largest in almost six years. Growth during the past two years is now 3.6% annually. That's slightly better than the 3.5% average pace during the robust expansion of the 1980s.

Stronger readings for net exports and consumer spending accounted for 80% of the revision. A smaller trade deficit was responsible for 60%, as exports grew more than previously measured and as imports rose less. As for consumers, instead of lifting their spending by 4%, they raised it by 4.6%.

Good news, right? Not for the bond market. Growth that strong suggests that the economy had plenty of momentum heading into the first quarter of 1994, which only reinforces the bond market's fears that the economy is getting closer to an inflationary flashpoint.

On Mar. 1, the GDP number, plus an ugly report from the nation's purchasing managers showing a surge in industrial prices, added more fuel to the recent sell-off in bonds (table). The yield on 30-year Treasuries hit an intraday high 6.80%, a level not seen in nine months. The sell-off continued on Mar. 2, but bonds finally closed a bit lower at 6.77%, and bond markets around the world are under heavy selling pressure.

The credit markets also fear further rate hikes by the Federal Reserve. But despite Fed Chairman Alan Greenspan's stated reason for Fed tightening--to fight inflation in the future, not in the present--the debt market seems sure that the Fed knows something about present inflation that the market doesn't. That's just not true.

The bond market may well be in a lather over nothing. What it chose to ignore on Mar. 1 was the tame inflation numbers contained in the fourth-quarter GDP report. The GDP fixed-weight price index, one of the broadest inflation measures, placed yearly inflation at 2.8%, the lowest rate in seven years. Another gauge, the implicit price deflator, pegged inflation at 2.2%, the lowest since the mid-1960s.

The bond market also pushed aside fresh evidence that economic growth this quarter is slowing down from last quarter's heady pace. That much seemed clear from the February purchasing managers' index and from January data on home sales and overall construction outlays.

To be sure, the fourth-quarter burst of economic growth was no fluke. It was broadly based and fueled by gains in personal income, corporate profits, low interest rates, and a pickup in foreign demand. And the economy does have momentum. But the growth spurt doesn't mean that inflation is about to heat up.

To begin with, first-quarter growth is slowing, probably to about 3%. In January, the three sectors that accounted for 84% of fourth-quarter growth--consumer spending, business investment in equipment, and housing--all started the first quarter more moderately. Also, the fourth-quarter surge in exports, helped by a large one-time shipment of aircraft, is not sustainable given the continued weakness in the major economies abroad.

Also, the manufacturing sector does not appear to be as peppy as it was last quarter. Although durable goods orders jumped 3.7% in January for the sixth rise in a row, big gains in aircraft and military bookings more than accounted for the overall increase. Those two sectors make up less than 10% of the total, but excluding them, January orders actually fell.

Moreover, shipments of nonmilitary capital goods, an indicator of equipment investment in the GDP numbers, dropped 3.8% in January. Demand began the first quarter barely above its fourth-quarter level, suggesting that equipment spending, up at a 25% annual rate last quarter, will make less of a contribution to GDP this quarter.

Looking at February, the National Association of Purchasing Management reported that its index of industrial activity dipped a bit, from 57.7% in January to 56.6%. The decline mainly reflected a slower pace of orders and production, says the NAPM.

What rattled the bond market, though, was a second sharp rise in the NAPM's price index (chart). This price index rose to 67%, the highest since October, 1990. However, these prices are mainly industrial commodities, such as basic metals, linerboard for corrugated containers, and various chemicals. Also, this is a diffusion index, which is meant to report the breadth of price hikes, not how much or how fast prices are rising.

Price increases for basic materials are not unusual as the manufacturing sector picks up. They are more a reflection of rising demand than potential inflation. Also, most of these prices are up from very depressed levels, as the NAPM pointed out. They would have to rise far higher before becoming a worrisome inflation signal.

Moreover, passing these higher costs to wholesalers, retailers, and consumers will be difficult. That's because of increasing resistance to higher prices, especially at the consumer level, and because stiff global competition is enforcing a new pricing discipline on U.S. producers.

Other signs of a cooler economy this quarter come from housing demand and consumer spending, although households seem determined to keep on buying at a solid pace. Inflation-adjusted consumer spending on both goods and services rose a healthy 0.5% in 1994's first month. Outlays for services, ahead 0.9%, led the increase, partly reflecting a surge in utility use during the harsh winter weather.

The January gain means that consumer spending started the first quarter at a 3.7% annual rate of growth above the fourth-quarter level. That pace is below the 4.6% rate of fourth-quarter growth, but it means that consumers should remain a positive force in first-quarter GDP growth (chart).

One reason: Income growth looks supportive. Although personal income fell 0.3% in January, a host of special factors caused the decline, especially lost rental income because of the earthquake. Excluding these factors, the Commerce Dept. said that income would have risen by 0.7%. Wages and salaries increased a hefty 1%.

Housing, which rose at a 31% annual rate in the fourth quarter, also will be more subdued this quarter, and that's true for building activity generally. Construction outlays, adjusted for inflation, fell 1.6% in January. Excluding public projects, private-sector spending dipped 1.2% (chart), as business construction declined by 2.2%.

Much of this weakness reflects the frigid weather. But despite the cold, housing outlays still managed to rise 0.3%, and residential spending began the first quarter well ahead of the fourth-quarter level.

The weather hit housing demand in January, as well. Sales of existing homes declined by 3%, to an annual rate of 4.22 million, while purchases of new single-family homes plunged 20.1%, to a 695,000 annual pace.

Still, those declines were from high levels. New home sales had hit an eight-year high in December, and the January level of existing home purchases was the second highest on record, eclipsed only by the December reading. Given warmer weather, construction generally and housing especially should rebound.

What the bond market needs to see is proof that these early first-quarter signs of moderating economic growth are real. It must also have more evidence that inflation remains subdued. That combination should emerge in the coming months, and when it does, long-term interest rates seem likely to fall back to more expansion-friendly levels.

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