Economy hot. Will rate hikes follow?
The Federal Reserve must consider whether it's time to raise interest rates, and what the effect could be on the job market.
NEW YORK — The US economy is cruising into spring with so much momentum that economists believe this is likely to be the best economic performance during the tenure of either President Bush. In fact, the economy is now so strong that unless it weakens significantly later this year, it could turn out to be as good as the Clinton boom years.
But this good news has an unusual twist: Corporate America has been the greatest beneficiary so far, and the titans of industry are being very tight with their money. So job growth is expected to remain modest.
This presents the Federal Reserve with a dilemma: Should it keep interest rates low until there are unequivocal signs that the job market is blooming, or should it start raising rates to fight off early signs of inflation? "This will be the next big test for the economy - how it adjusts to higher interest rates," says economist Mark Zandi of Economy.com.
Clues about the Fed's thinking could come as Chairman Alan Greenspan testifies this week before the Senate Banking Committee and the Joint Economic Committee.
Some signals are already coming from the long-term bond market, which often anticipates Fed moves. It has hiked interest rates by about half a percentage point. This is starting to work its way through the economy in the form of higher mortgage payments. The initial impact has been on people refinancing their mortgages. According to the Mortgage Bankers Association, refinancing applications for the week of April 9 fell by more than 30 percent.
Still, most speculation is centering on when the Fed will hike short-term rates. "The consensus is zeroing in on August as the time when the Fed raises interest rates by a quarter of 1 percent," says Stuart Hoffman, chief economist at PNC Financial Services Group in Pittsburgh. "But this is only half the game. The other half is how fast and how far."
Another important clue about future Fed policy will come on May 4, when the Open Market Committee meets to discuss the economy and interest rates. In past statements, the Fed has said it could remain "patient." Analysts have interpreted that to mean it won't raise interest rates until the economy has fully recovered and the threat of deflation has disappeared. That view is likely to change.
"They will probably put the bias between inflation and deflation back to equal," says Chris Burdick, senior market analyst at the Schwab Center for Investment Research in Denver. "This is expected to set the stage for the rate hike," he says, adding, "But I think they need more data."
One tick up in interest rates, however, is not expected to do much to slow the economy. "We have had enormous stimulus for a long time. The results are just beginning to show," says David Kotok, chief investment officer at Cumberland Advisors in Vineland, N.J.
The latest numbers illustrate the effect of this stimulus. The month started with a report showing a large increase in the number of Americans working in March. Then, retailers reported strong sales. And capital spending by business is picking up. This strength is expected to result in a first-quarter annualized growth rate of about 5 percent, after 4.1 percent in the fourth quarter of last year.
If the economy continues at close to this pace, it will be best year since President Bush took office. It would also top any year during the first Bush administration, when the best year was a 3.5 percent rise in 1989.
As the economy has improved, some analysts have become concerned about a new issue: rising prices. Last month the consumer price index (CPI) rose by 0.5 percent, driven in part by higher gasoline and apparel prices.
Mr. Kotok believes the Fed is not likely to react to the March number. Instead, he says Mr. Greenspan looks at the monthly personal consumption expenditures (PCE) deflator, which better represents what people spend. "If steak goes up in price, then they switch to chicken," he explains.
That number is rising, but not as fast as the CPI.
Although the economy is strong, it still may face some challenges if there is another terrorist incident or international news begins to weigh consumers down. Indeed, the latest University of Michigan consumer sentiment numbers showed a surprising dip. "It may have been the war in Iraq instead of the economy," says economist Bob Brusca of the New York-based Fact and Opinion Economics.
Some economists believe productivity gains will start to diminish. "I suspect productivity numbers will come down as the utilization of labor expands," says Jay Mueller, an economist at Strong Capital Management in Milwaukee. On an anecdotal level, Mr. Mueller is already seeing signs of new hiring - such as friends who have been out of work. As he drives to work every day in Wisconsin, he sees many "hiring" signs.
"People have been very careful with head count," he says. "Now I think they are beginning to believe demand is not ephemeral."