U.S.: Good Bye, Endless Summer. Hello, Higher Rates?

Strong demand may force the Fed to take out more inflation insurance

It's crunch time in paradise. Wall Street's unusual volatility of late highlights a growing perception that the heavenly combination of strong growth, high profits, low unemployment, tame inflation, and a sidelined Federal Reserve has about run its course. The snake in this economic Eden is overly strong demand that is refocusing attention on the threat of higher inflation in 1998--and the Fed's possible preemptive response to it in coming months.

That's because the economy looks far different than the expectation outlined by Fed Chairman Alan Greenspan only a few weeks ago. In congressional testimony on July 22, Greenspan said: "Unless aggregate demand increases more slowly than it has in recent years--more in line with the trends in the supply of labor and productivity--imbalances will emerge." He went on to say that second-quarter demand had eased, and that the Fed's forecast was for economic growth to remain moderate, in the 2% to 2.5% range in coming quarters. Under that scenario, a rate hike was highly unlikely.

Well, look again. As it turns out, second-quarter economic growth was faster than the 2.2% pace first reported, and final demand--spending by consumers, businesses, government, and foreigners--remained as sturdy as ever, even after accounting for the temporary slowdown in consumer spending. Moreover, with consumers on the rebound, demand is off to a strong start this quarter: July retail sales and car buying suggest that household demand is rising at an annual rate of about 4%. If overall final demand grows 3% this quarter, its growth over the past year will be the fastest pace since the early stages of the recovery from the 1990-91 recession.

ALTHOUGH THE PRICE INDEXES remain tame, the markets know that the Fed chief's own words have put him at a crossroads. That's because excessive demand--beyond that which workers and machines can satisfy--is the root cause of inflation. So, will Greenspan leave interest rates alone, taking the New Economy gamble that technology-driven gains in productivity have enhanced the economy's ability to grow faster without generating inflation? Or will he take out some more inflation insurance in the form of higher rates?

Surprisingly strong demand, especially by consumers, tilts the odds in favor of tighter policy. Although robust outlays for business equipment and buildings are not inflationary, since they enhance the economy's ability to meet demand, consumers and foreigners are putting demands on that production capacity as soon as it comes onstream. Fueled by rising jobs, incomes, confidence, and equity gains, households appear to be spending this quarter at the fastest four-quarter pace in more than three years. And exports are growing at the fastest yearly rate since 1989.

The latest data point to the third-quarter's strength. Consumer confidence rose in August, nearly reaching the 28-year high hit in June, according to the Conference Board. Also, sales of existing homes rose 2.2% in July, to an annual rate of 4.24 million, and although durable-goods orders in July fell 0.6%, they managed a 0.3% increase in the month, excluding a big drop in the volatile transportation sector. The trend in orders is strongly upward. Both new orders and home sales began the third quarter well above their average levels of the second quarter (charts).

IF VIGOROUS DEMAND does impel the Fed to act, then a rate hike would not sit well with the stock and bond markets, which have only partially priced in the expectation of a hike. For example, the current spread between the 5.5% overnight federal funds rate and 5.95% two-year Treasury notes is less than a half point. It's typically much wider when the market fully anticipates Fed tightening. Also, higher long-term bond yields would imply lower stock valuations at a time when earnings growth is slowing.

Right now, there are only scattered hints that demand is straining available production capacity. But with spending this strong, signs are likely to multiply this fall. Utilization rates in manufacturing have actually fallen in recent months, but that partly reflects strike-related weakness in auto output. Factory production grew at an annual rate of 3.7% last quarter, less than the 4.3% pace of capacity growth, but excluding autos and parts, manufacturing output rose at a 4.9% clip, and auto production is scheduled to pick up substantially as the third quarter progresses. One sign of potential strain: Factory delivery times in July were the slowest in more than two years.

A key issue in the second-half growth outlook is inventories. The first half's rapid growth in stock levels cannot continue for long, because it would require demand growth of greater than 4% to justify that pace of buildup. However, last quarter's inventory surge reflected the temporary slowdown in consumer spending. Also, much of the stock buildup appears to be imports, so the impact of reducing them will not fall completely on U.S. production.

THE BIGGEST STRAIN ON RESOURCES right now is in the labor markets. And by all signs, the unemployment rate, already at a 24-year low of 4.8%, is going to fall further in coming months.

The Conference Board's August report on consumer confidence said that 37.6% of consumers thought jobs were plentiful, a new high for this expansion, while only 16.6% thought they were hard to get (chart). And the latest survey of 16,000 employers by Manpower Inc., the temporary help firm, shows that corporate hiring demands for the fourth quarter will be the strongest since 1978.

Amid such tight labor markets, the Teamsters' victory in the strike against United Parcel Service Inc. keeps the issue of wage acceleration on the Fed's front burner. Annual wage growth in the service sector, which is less vulnerable to foreign competition than the goods-producing sector, was 3.4% last quarter, and it is already creeping up from 2.8% two years ago.


While consumer inflation in services has been about steady, core goods inflation, excluding energy and food, has fallen sharply over the past year and a half in response to the 20% rise in the trade-weighted dollar. Prices of non-oil imported goods have fallen 3.5% in the past two years--and a fourth of such goods purchased are imports. But that inflation depressant cannot be sustained in 1998, unless the dollar's runup continues.

Chairman Greenspan may be sympathetic to the New Economy view that the economy can grow faster without inflation. But his policy actions demonstrate that when push comes to shove--that is, when the evidence shows that excess demand is straining the economy's resources--he will move preemptively to ease those strains before inflation can take hold.

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