Damn The Rate Hikes, Full Speed Ahead

As if to add an exclamation point to 1994, the data are emphasizing the year's two biggest surprises: unexpectedly strong growth and the Federal Reserve's startling hikes in interest rates.

The latest numbers give no hint that growth is cooling off in the way the Fed would like. November payrolls surged 350,000, a gain characteristic of the early-boom stage of a recovery, not a 31/2-year old expansion (chart). Despite rising rates, October sales of new houses are up 16% from June, and November demand for U.S.-made cars and light trucks matched March's 71/2-year high.

Moreover, real consumer spending in October was up at an annual rate of 3.5% from the third quarter, compared with last quarter's 3.3% increase, suggesting that the pace of buying this quarter could end up even faster than last quarter. And U.S. purchasing managers said November industrial activity hit a 10-year high.

Admitting that the Fed had somewhat underestimated the economy's strength, Chairman Alan Greenspan preached his anti-inflation sermon to Congress on Dec. 7. He warned that "the good economic times could tempt producers into raising prices soon to cover rising costs." That inflation alarm was echoed by the Fed's latest survey of regional economies released on the same day.

Given that, further rate hikes seem assured. There is increasing speculation that the Fed will move as early as the Dec. 20 policy meeting. But given the large three-quarter-point increase on Nov. 15, the Jan. 31-Feb. 1 powwow might be the better bet.

ONE INTERESTING SIDELIGHT to the economy's bullish cast, which suggests that the Fed might delay its next move, is the bond market's recent rally. The yield on the benchmark 30-year Treasury bond fell below 7.9% on Dec. 6, before the Orange County (Calif.) bankruptcy hit the municipal market.

Although strong growth portends higher inflation, the bond market may be starting to believe in the widely forecast 1995 slowdown--and in the Fed's resolve to make it happen.

The November employment report challenges that resolve. The job gain was not only one of the largest this year but also one of the broadest. Some 61% of the 356 industries surveyed added workers to their payrolls. High-paying goods producers put on the most new hires in 41/2 years.

Those gains included 51,000 jobs in manufacturing and 71,000 in construction. Unusually warm weather exaggerated the construction increase, but the factory additions look real. Combined with October's 42,000 new factory slots, that's the largest two-month gain in manufacturing jobs in six years. Service producers added 230,000 workers, close to this year's average monthly gain.

In addition, further job gains will push the unemployment rate lower in coming months, just at the time when joblessness is already at levels that heighten worries about inflation's No.1 fuel: faster wage growth. The jobless rate fell to 5.6%, down from 5.8% in October. In manufacturing, the unemployment rate shrank to just 4.9%.

The chief implication of the November job data is that fourth-quarter growth in real gross domestic product is on track to match--or even exceed--last quarter's 3.9% pace. Although overall work time fell in November, reflecting an 18-minute drop in the workweek, total hours worked this quarter are still running 4.7% above the third quarter, at an annual rate. That's more than twice the third-quarter increase. Even if productivity shows no rise, that means real GDP growth could easily reach 4%.

MANUFACTURERS, fueled by shop-happy consumers and a relentless boom in business-equipment investment, are certainly feeling their oats. The National Association of Purchasing Management's index of industrial activity jumped from 59.7% in October to 61.2% in November.

The index, comprising production, orders, delivery times, inventories, and employment, posted a third consecutive increase (chart). The production index was the highest since 1983, says the NAPM, and the orders index was near last January's level, which was a 10-year high.

The industrial sector's vigor should carry forward into 1995, if only because consumers seem determined not to let higher interest rates get in the way of their holiday shopping. Retailers went into the season with heavy inventories, but solid sales are paring them down and clearing the way for reordering and further output gains.

Shoppers were on a roll even before the season began. In October, real consumer spending jumped 0.7%. November results will not be as strong, given the month's moderate reports from retailers. But post-Thanksgiving activity appears to have picked up.

One source of buying power stems from consumers' new affinity for credit purchases. Households continued to add lustily to their installment debt in October, and the increase for all of 1994 is on a record-setting pace.

THE KEY SUPPORT under borrowing and spending is the strong labor market, which is generating healthy income growth. Personal income soared 1.4% in October, and even after adjusting for taxes and inflation, real disposable earnings still rose a stout 1.3%. That means real income growth started the fourth quarter at an annual rate of nearly 7% above last quarter, suggesting that consumers are flush with cash as they prepare for the holidays.

Better job markets are also a big reason why home buying is holding up, even though mortgage rates have jumped two percentage points since the Fed began to tighten. Sales of new single-family houses rose 1.3% in October, to an annual rate of 726,000, after a 5.6% gain in September (chart). The proliferation of cheaper adjustable-rate mortgages is one reason for this resilience. But consumers are also just better off. Third-quarter mortgage delinquencies, for example, dropped to the lowest level in 21 years, says the Mortgage Bankers Assn.

To be sure, the economy is destined to slow down, probably by the second half of next year. Despite the buoyant demand now, the housing sector is already flashing some signs of slower growth later on. Contracts for new residential construction, which is a leading indicator of actual building, have been falling in recent months, according to F.W. Dodge Div. / McGraw-Hill Inc.

More broadly, the government's index of 11 leading indicators, designed to predict the economy's course six to nine months in advance, fell in October for the first time in 15 months. Of interest to inflation worriers: The indicator posting the largest decline was commodity prices, which slowed for the second month in a row.

Given the Fed's resolve, the surprise of 1995 is not likely to be a repeat of 1994's muscular growth. Instead, higher rates will eventually bend this expansion more in line with the Fed's wishes. But for a little while longer, at least, the present dream combination of strong growth and low inflation will continue to feel mighty nice.

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