U.S.: An Economy This Warm Won't Cool On Its Own

Robust growth may require the Fed to hike interest rates into 2006

The latest run of strong data has turned a lot of heads, especially because of the unexpected oomph it implies for the economy in the second half. It wasn't supposed to be that way, based on most forecasts from a few weeks ago, including projections from the Federal Reserve. Now many economy watchers are raising their forecasts for the second half into the 4% range. If that scenario plays out, it could have big consequences for the labor markets, inflation, and Fed policy.

That's because, instead of slowing to a more moderate pace that would ease the Fed's concerns about future inflation, the economy looks set to continue to grow faster than its optimal "speed limit" for a third consecutive year. That rate is the one fast enough to create sufficient jobs to keep all workers employed but slow enough to ensure price stability. It is now generally recognized to be 3% or a shade higher.

For the past two years the economy has grown at an annual rate of 4.1%, according to the historical revisions to real gross domestic product reported by the Commerce Dept.'s Bureau of Economic Analysis on July 29. Continued rapid growth will keep using up whatever slack remains in the labor markets and in production capacity. And the recession was so shallow that not much slack was created in the first place. That's a road toward tighter labor markets and more upward pressure on wages and prices that the Fed will not want to go down.

For months the financial markets have been looking for the Fed to stop hiking short-term interest rates when its federal funds rate gets to a "neutral" level, which is the funds rate that neither helps nor hurts growth. But if the economy is zipping along at a 4% pace in the second half, and if inflation keeps picking up, the Fed may feel compelled to blow right by the neutral mark and push rates to a level that actually begins to restrict growth.

THE BEA'S REPORT on real GDP for the second quarter laid out the case for second-half strength. The top-line number showed that real GDP grew at an annual rate of 3.4% last quarter, down from 3.8% in the first quarter. But it was the mix of growth that was important. Overall demand for U.S.-produced items jumped 5.8%, lifted by an 11% advance in business outlays for equipment and a 12.6% surge in exports. But a lot of that demand was satisfied by inventories already produced in earlier quarters. As a result, after inventories had ballooned in the first quarter by $58.2 billion, at an annual rate, business then cut their goods on hand by $6.4 billion in the spring. That shift subtracted 2.3 percentage points from the quarter's GDP growth.

But that inventory drawdown sets up a rosy picture for production in the second half. Since businesses have cleared out so much of their excess stockpiles -- a trend seen most pointedly in the auto industry -- companies will need to ramp up production to meet the gains in demand in the second half.

Surging Demand Is Powering Growth
That's already happening. Consumer spending got off to a roaring start in the third quarter, with car buying surging to a 20.9-million annual rate in July, the second highest on record. Plus, the industrial sector was busier in July. The Institute for Supply Management's business activity index for manufacturers rose to 56.6%, from 53.8% in June. New orders were up strongly for the second month in a row, and the ISM's production index increased to 61.2%, a 10-month high.

The ISM said that given past trends, the average for the index so far this year corresponds to real GDP growth of 4.3%. Given low inventories and the surge in consumer spending at the start of the third quarter, growth of about 4% in the third and fourth quarters looks very likely.

USUALLY THE MOST RECENT quarter's GDP says the most about the outlook for growth and prices. But this time around, numbers from previous quarters also offer some insights. The BEA's annual revisions, which go back to the first quarter of 2002, show that output grew a bit more slowly, by 0.3 percentage point per year, from 2002 through the first quarter of 2005 than earlier reports had shown. They also show that economywide inflation was 0.3 point per year higher.

Most important, the BEA's revisions show that the Fed's favored price measure, the price index for personal consumption expenditures minus energy and food, now indicates that inflation was notably higher last year than previously thought, 2.2% instead of 1.6% . For the first two quarters of 2005, the annual rate is running at 2.1%. That means inflation last year slightly exceeded the Fed's expectation, and it is on a pace to do the same thing this year. In both 2004 and 2005, the Fed projected that this price gauge would grow in the range of 1.75% to 2%.

Interestingly, almost all of the upward price revision was in services, which are labor-intensive and less sensitive to global competition. The PCE index now shows service inflation rising at a 3% annual rate from 2001 to the first quarter, instead of 2.7%. Service prices rose at a similarly strong 2.9% rate in the second quarter. And in July, the ISM reported a sharp increase in the prices paid by nonmanufacturing companies.

The pickup in inflation suggests that strong demand may already be straining some areas of the labor market and production facilities to keep up. And the strains could get even worse if demand from both consumers and businesses in the second half increases speed.

FOR NOW, THE BIGGEST PLUS in the inflation outlook is that wage pressures remain tame. The employment cost index for private workers shows wages, salaries, and benefits rising 3.1% in the year ended in the second quarter, down from a 4% pace the previous year.

That slowdown largely reflects a sharp slowing in benefits as businesses rein in their health-care expenses. And with the cost of benefits easing, businesses can hire more workers without worrying that skyrocketing health-care bills will ruin their bottom lines.

Revisions Put Inflation A Bit Higher
But the wage picture could change quickly if the jobless rate heads toward 4.5% by yearend, which is a real possibility. Keep in mind that real GDP averaged just 3.6% in the first half, and joblessness fell from 5.4% to 5% in June. Tighter labor markets are likely to push up wages, especially in the service economy. Also, productivity is slowing, so better efficiencies will not offset the cost of higher pay to the extent that they did in the past.

To be sure, the growth rate that defines the economy's noninflationary "speed limit," or "sustainable growth rate" as the Fed calls it, is always up for debate. The Fed does not publicly comment on what that rate might be. But it is interesting to note that in its July forecast, the Fed projected that if economic growth comes in at its expectation of around 3.5%, then the unemployment rate would remain at 5% and inflation would hold steady at just under 2%. That twin stability is a theoretical definition of the speed limit.

Preemptive policy has been a hallmark of the Fed under Alan Greenspan. And if the economy is growing 4% or more, the Fed may not have the leisure to wait and see if a neutral policy will keep inflation in check.

By James C. Cooper & Kathleen Madigan

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