U.S.: The Economy Slows -- From A Gallop To A Canter

A steadier pace, along with Fed rate hikes, should calm inflation fears

When the Federal Reserve did the expected on June 30 and raised interest rates, its aim was to start removing the excessive stimulus coursing through the economy. But changes in monetary policy take a while to work through the system. Recent news reports suggest that demand may have been easing before the Fed increased its target for the federal funds rate by a quarter-point, from 1% to 1.25%. That slowing should make the Fed's job easier.

In its accompanying statement, the Fed said the upside and downside risks to achieving sustainable economic growth and price stability are about equal. Policymakers also noted, even after the rate hike, that monetary policy "remains accommodative," and they repeated their goal to remove that stimulus at a "measured" pace. However, the Fed left the door open for more rapid hikes if needed "to fulfill its obligation to maintain price stability."

The Fed's assessment of the economy and its hints about future policy moves echoed sentiments mentioned after the May 4 meeting. This consistency reassured the financial markets. The "measured" language is widely viewed as a signal that the Fed will continue with quarter-point hikes, probably at each meeting, until the funds rate reaches a level that neither helps nor harms growth.

Don't expect the economy to react immediately to the June hike. True, in today's just-in-time environment, financial markets adjust more quickly than they once did to Fed action. But policy moves work best when a few of them have accumulated in the system. So even if the Fed bumps up rates at every meeting, the effects won't be fully felt until much later this year.

For now, the economy seems to be responding to the financial and policy conditions in place before June 30. Consider the spring increase in long-term rates. Part of the rise was caused by the expectation of Fed action, but part was also a response to surprise jumps in the inflation numbers. Rising yields caused consumers to buy homes at a record pace in May. That surge added to second-quarter growth -- but probably stole sales from the third and fourth quarters. Higher mortgage rates also cut into refinancings, which had been a big source of funds for consumer spending. In addition, the boost from last year's tax cuts is waning.

DON'T CONFUSE moderate growth for meek, though. Growth in real gross domestic product is probably slowing to an annual rate of below 4% in the second half, down from a gallop of 4.8% over the year ended in the first quarter. The projected pace will still be fast enough to generate new jobs, profits, and incomes. And depending on future inventory growth, real GDP has the potential to beat expectations.

More important for future interest rates, the easing in growth means inflation won't have a chance to gain much traction. So the Fed can proceed at its preferred gradual pace. That means there is less potential for disruption in the financial markets or in the economy.

Home Sales Soar TO New Record High
A key factor in the second half, given the loss of fiscal stimulus and rising energy prices, will be consumer spending. It slowed last quarter, in part because consumers were paying more for gasoline. Real consumer purchases in May rose 0.4%, after no gain in April. So far in the second quarter, real spending is growing at an annual rate of 1.9%, half the 3.8% advance in the first quarter.

HOWEVER, CONSUMER ATTITUDES and income gains suggest that demand will rebound this summer. Real aftertax income has increased at a 2.6% annual rate so far in the second quarter, on top of a 4.9% gain in the first. Since income is rising faster than spending, consumers are building a cushion that can finance future purchases.

That extra income -- along with expectations for bigger paychecks ahead -- is contributing to renewed economic optimism. The Conference Board's consumer confidence index rose nearly nine points in June. At 101.9, the index is the highest in two years.

Consumers are particularly upbeat about job prospects in the second half. A growing percentage of respondents also expect their incomes to be higher six months from now. Fatter paychecks will lift spending even as Fed rate hikes begin to slow the pace of household borrowing.

Besides consumers, look for two other sectors -- imports and inventories -- to play big roles in the economy's second-half performance while at the same time pos- sibly aiding the Fed in its goal to keep a lid on inflation.

Inventories and imports, though often overlooked, were prominent in the latest report on first-quarter GDP. The Commerce Dept. made an unusually large change in real GDP growth. The economy grew at a 3.9% annual rate instead of the previous rate of 4.4%.

Commerce said imports rose at a 10.4% annual clip, faster than the 5.9% rate previously reported. That lowered economic growth, since imports are subtracted from the GDP calculation because they represent domestic demand satisfied by overseas output.

For the Fed, the increase in imports will make inflation-fighting easier. First, there is less danger that the U.S. economy can overheat when much of domestic demand can be satisfied by foreign production capacity. Second, global competition limits price increases here in the U.S., especially for goods producers.

THE CONTINUED RISE in imports was not unexpected. The more U.S. demand grows, the more the economy attracts imports. The latest inventory trends are a bit surprising, though. Economists had expected inventory rebuilding to significantly boost economic growth in the first half. But the GDP data plus monthly numbers suggest that companies are still having a hard time restocking their shelves.

Real nonfarm inventories grew by $25.5 billion in the first quarter, less than the $28.2 billion previously estimated. The monthly inventory data, which are not adjusted for price changes, show total business inventories rising just 0.5% in April, while May stockpiles of durable goods rose 0.4%, even though factory output soared in those two months. The inventory gains are on a par with the monthly rises averaged in the first quarter. That's a sign inventories last quarter accumulated at about the same pace as in the first, resulting in little additional growth in real GDP.

Consumer Spirits Turn Much Brighter
Yet that weakness could be an advantage in the second half -- and reverse some of the recent price jumps. If businesses finally get serious about building inventories, the increase in orders will push up industrial production and sales. In fact, a concerted effort to restock could cause real GDP growth to pop up to 5% for a quarter. Plus, higher inventory levels would lessen some of the delivery delays that have contributed to the buildup of cost pressures lately.

Easing nascent inflation fears will be important, since the relief offered would allow the Fed to move at its well-communicated measured pace. Policymakers are aware that, like a ship on the open sea, the U.S. economy cannot be turned on a dime. And the Fed wants plenty of time to pilot the economy on its intended course of steady growth and low inflation.

By James C. Cooper & Kathleen Madigan

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