New year heralds good fiscal tidings

William Sullivan, executive director of fixed-income research at Morgan Stanley, worries that a bomb might go off in a shopping mall. "If something calls into question the safety of American families in public places, that would be a very negative development for growth and the economy as a whole," he says. "It would be devastating in the short run."

Despite such concerns, most economists expect the US economy to continue to benefit from the forces that have been propelling it in the second half of 2003. For example, most Americans will continue to benefit from the cut in tax rates. Although this is already in most paychecks, it will also show up next year when people file their 2003 income taxes: The tax cut was retroactive to Jan. 1, but withholding rates didn't account for it until July 1. This means many people will have larger-than-expected income tax refunds, boosting consumption.

More tax moves could be in the offing, says Peter Orszag, a senior fellow at the Brookings Institution in Washington. He sees a variety of signs the administration will propose an initiative that gives tax breaks on the interest for "Lifetime Savings Accounts." This would allow everyone to put up to $7,500 per person per year into a tax-free account. The money could be used at any time to buy just about anything.

On the other hand, Mr. Orszag has no doubt that Congress will quickly repeal the tax breaks now given to corporations for exporting. They have been ruled illegal under the World Trade Organization, and Europe has threatened retaliation if the US doesn't act soon. "The question is how they will be replaced," he says.

While Congress debates future fiscal stimulus, most analysts expect the Federal Reserve to continue its easy-money policy - that is, keeping interest rates low. The bulls reason that Fed Chairman Alan Greenspan will want to see convincing evidence that inflation is picking up before the Fed raises rates. For the past six months, the core rate of inflation has slowed to a 1 percent annual rate.

"We think they will be very patient," says Dudley. "We don't think they will tighten at all for 2004."

But others, like Kotok of Cumberland Advisors, envision a gradual increase in rates by the second half of the year. "A 1 percent federal funds rate [the current rate] is inconsistent with economic growth of 4 to 5 percent and inflation of 2 percent," he says. "The question is how they make the transition to something higher."

Any increase in rates could hurt the many consumers who are already burdened by high debt loads, says Mr. Sullivan of Morgan Stanley. "So much debt is priced to the open market, and it ratchets up as rates go higher," he explains.

Even Sullivan, however, who is skeptical about the extent of the economic bounce in 2004, admits there could be pleasant surprises. "We've got a big resilient economy, but it doesn't negate the fact there are challenges."

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