Interest Rates: Enjoy The Summer, Then Start Worrying Again

A rate hike is unlikely now, but growth could bring back inflation jitters

Wall Street dodged a bullet. The financial markets had hunkered down, anxiously awaiting the crucial early August volley of data that would determine whether or not the Federal Reserve would hike interest rates at its Aug. 20 meeting. As one report after the other came in either near or below expectations, bond prices took off like a rocket and stocks zoomed close behind, as the markets surmised that the chances of a rate increase anytime soon had dropped sharply.

What does this onslaught of data on everything from jobs to wages to gross domestic product say about the outlook? Most important, as the stock and bond rallies show, the numbers did not "persuasively suggest an intensification of oncoming inflationary pressures." That's classic Fedspeak direct from Chairman Alan Greenspan, describing the criterion for Fed tightening.

More recently, the Fed's beige book, a roundup of economic activity in the Fed's 12 districts, reported that economic growth had "moderated" in some regions and that "wage pressures remained subdued."

With rate-hike worries aside, the yield on the benchmark 30-year Treasury bond dropped to 6.75% on Aug. 6, from 7.10% before the latest data came out. And the Dow Jones industrial average broke through 5700 again on Aug. 7, wiping out all of the losses incurred during the steep July correction. The bond market so far seems undistracted by the potential impact on the deficit of Presidential hopeful Bob Dole's tax-cut plan, but it's a factor that bears watching.

ALL THIS DOESN'T MEAN, however, that the markets--or the Fed--are off the hook indefinitely. The latest data also does not suggest that the economy is slowing to a pace that would prevent inflation fears from resurfacing later on. To be sure, third-quarter growth is unlikely to match the second quarter's 4.2% surge in real GDP, the fastest pace in two years. But even though July's data looks soft in places, the evidence that growth is slipping below 3% is far from compelling.

The breakdown of second-quarter GDP shows one reason. Final demand by consumers, businesses, government, and foreigners rose at an annual rate of 3.5% last quarter, even faster than the first quarter's 3% pace. At the same time, inventory growth, outside of the auto industry, has slowed (chart). Excluding the strike-related ups and downs of auto inventories, second-quarter stockpiles grew at the slowest rate in three years. Heading into the second half, inventories are very lean relative to demand, a condition that will generate additional ordering and output.

That's why the sudden weakening in the July report from the National Association of Purchasing Management may not be a true reflection of the industrial sector. The NAPM's index of industrial activity fell sharply last month, to 50.2%, from 54.3% in June.

The index may have looked weaker because the seasonal adjustment process may not be capturing the increasingly early summer shutdowns in the auto industry, as carmakers retool for the 1997 model year. That effect is already known to have distorted the data on new jobless claims and the Chicago area purchasing managers' report.

The drop in the NAPM's index was a major factor in the markets' rally, but it will take the August index to confirm whether the July decline was real or just a head fake. The Fed's beige book noted that manufacturing showed signs of accelerating, with factory hiring on the rise in many regions.

THE OUTLOOK FOR SPENDING, meanwhile, remains firm. In the second quarter, demand got its strength from faster growth in the consumer, housing, government, and export sectors, while the drags were in imports and slower capital investment. More imports, though, are just a reflection of strong U.S. demand.

On the surface, the slowdown in capital spending is a little more troubling, given its huge contribution to this expansion. The downshift is centered in traditional low-tech sectors (chart), such as transportation equipment and industrial machinery, while outlays for computers and peripheral items are still booming, helping to lift the total. Looking ahead, though, capital spending will get new support from this year's pickup in the economy, along with good, although slower, profit growth, rising capacity utilization, and the continued low cost of capital.

At the same time, the other sources of demand show no signs of falling out of bed. In particular, exports may even speed up, given Europe's new momentum, Japan's firmer footing, Canada's improvement, and Mexico's recovery. And the consumer sector should remain solid, given good job growth and bigger pay gains amid tight labor markets.

WITHOUT A DOUBT, consumers have been the year's biggest surprise. Their spending rose a stout 3.7% last quarter, a shade faster than the first quarter's 3.5% pace. That's the strongest two-quarter advance in 3 1/2 years.

Third-quarter spending appears to have started slowly. Sales of domestic and imported cars and trucks in July fell to an annual rate of 14.3 million, from June's 15.2-million rate, which was also the average for the second quarter. Also, retail surveys reveal softer department-store sales, although analysts say the distraction of the Olympics coverage, especially on weekends, cut into sales, both in stores and on car lots.

Now that all the gold medals are packed away, consumer spending should show more gusto. That's because consumers started the third quarter with more confidence and money, and you don't have to look much beyond the labor markets to see why.

Payrolls, after increases averaging 237,000 new jobs a month during the first half, rose 193,000 in July. That's a pace that will keep the unemployment rate at July's tight 5.4%--or heading lower. And it will allow wages to grow at a faster clip. Although hourly earnings in July dipped 0.2% after surging 0.8% in June, the trend in wage growth remains up for both manufacturing and services (chart).


The Fed will be watching that potentially inflationary trend closely in coming months, but pay hikes will also provide healthy gains in consumer incomes. Personal income advanced a sturdy 0.9% in June, the largest monthly increase in a year and a half. And the rally in the markets will support both consumer spending and housing, as fixed mortgage rates will be heading down.

For now, at least, Wall Street has put aside its fears of overly strong growth, rising inflation, and Fed tightening. But until the economy shows clearer signs that it is slowing to a pace that will keep the Fed on the sidelines, the markets could still get hit by shrapnel from any unexpectedly strong data.

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