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Soft or Headed South?

There are conflicting signs on the economic horizon.

12:00 AM, May 10, 2005 • By IRWIN M. STELZER
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SOFT PATCH or the beginning of a downturn--that's the question that divides America's economy watchers. Last week the Federal Reserve Board's monetary policy makers enlisted in the soft-patch camp, and kept to their program of "measured," repeated, one-quarter point increases in interest rates. This reflects three things.

First, there is an institutional bias against changing policy. Once Fed chairman Alan Greenspan has settled on a policy, the burden of proof rests on those who want to change it. And that is a tough burden to meet--even the expert members of the Fed's monetary policy committee have difficulty matching the chairman's skill at teasing a coherent view from often conflicting facts.

Second, the Fed's economists believe that a lot of the bad news that is dominating the headlines will prove transitory. True, as the Fed recognized, "Recent data suggest that the solid pace of spending growth has slowed somewhat . . . " But once the shock of higher gas prices wears off, continued improvements in the job market should restore consumer confidence, which has fallen recently, but remains above year-ago levels.

And improvements there are. The government reported the creation of 275,000 new jobs in May, and revised its February and March estimates up by a total of 100,000. The National Association of Business Economists' recent survey suggests that wages and salaries have begun to rise sharply, after more or less stagnating, adding to consumers' purchasing power and confidence.

Indeed, there are strong indications that America's consumers are unlikely to pull the economy down. The housing market remains strong, even though a decline in mortgage applications suggests that the recent torrid pace of new home sales--they rose 12.2 percent in March to a record--will not be maintained. And the widely reported problems of General Motors and Ford, which seem unable to produce cars that people want to buy and have had their credit downgraded to "junk" status, obscure the fact that total car sales, including those by Japanese car makers, strengthened last month.

The news from the business sector also struck many observers as sufficiently dire to persuade the Fed to stop increasing rates. Manufacturing activity slowed, and the Institute for Supply Management reports a drop in new orders. Business investment continues to grow, but at a far slower pace than earlier this year. In March, capital goods orders recorded their sharpest decline in almost three years.

Anecdotes round out the picture. IBM has announced that it will be laying off as many as 13,000 workers, primarily in Western Europe; the textile industry is reeling from mounting imports from China; more airline bankruptcies seem the likely result of rising fuel prices; and the financial services sector is coping with Elliott Spitzer's desire to nail more trophies to his wall.

But early indications from Thomson First Call are that first-quarter net income for America's corporations will be up over 13 percent, which may explain why the NABE says its survey suggests that capital spending for the balance of this year will be "robust."

So the Fed is unconvinced that the "soft patch" warrants changing its view that "pressures on inflation have picked up in recent months," and that rates should continue on an upward path. Last month, core consumer prices--excluding energy and food--posted their largest one-month gain in over two years. And the Fed's favorite measure of inflation rose at an annual rate of 1.7 percent, near the top of the 1.5 percent to 1.75 percent range that the Fed has been expecting.

Again, add anecdotal evidence. Dow Chemical announced that it has been able to jack up products prices by an average of 26 percent, Caterpillar Inc. reported the return of pricing power, and several hotel chains were able to raise room rates.

So the "measured" increases are likely to continue. But fears that the pace of interest rate increases will accelerate seem unwarranted. Greenspan remains convinced that productivity improvements, although unlikely to continue at an annual 4 percent clip, will offset some of the price increases. The consensus forecast is for future rises in productivity on the order of 2.6 percent annually, the rate recorded in the first quarter of this year. That would offset a good portion of the projected increases in labor compensation, and keep the annual growth of unit labor costs to only a bit more than 1 percent.

The Fed is also betting that it need not accelerate its measured increases in interest rates because the worst of the current oil-price run-up is just about over. Prices might not come down very much, but they seem unlikely to rise to anything like the $100 per barrel level that was being bruited about a few weeks ago.