Hot Economy, Lagging Fed
Growth is strong, sales are booming, dollar's weak.


David Malpass

Retail sales growth is accelerating, inventories are rising, and business investment is surging. By many reliable measures job growth is strong (though not yet payroll job growth). And the 2003 Bush tax cut will cause disposable income to bulge in the first half of 2004, also providing a continued economic stimulus through its reduction in the cost of capital.

Weighing all these indicators together, there’s enough reason to be optimistic about the economy. In the coming quarters, Americans can expect very fast economic growth, beginning with a more-than 5 percent surge in GDP for this year’s fourth quarter (which follows the stellar third-quarter mark of 8.2 percent).

In fact, the economy may be at more of a risk of overheating than stalling. Still, the naysayers abound. Some economy watchers say idle capacity, higher mortgage rates, and consumer debt are important constraints in the outlook. But their conclusions are wrong, as are their facts.

Here are some quick observations on what’s going on in the economy.

November retail sales jumped a larger-than-expected 0.9 percent from October, led by strong auto sales. The 0.3 percent month-over-month decline originally reported for October was revised to unchanged, meaning actual dollar sales in October and November were way above earlier indications. Sales excluding autos increased 0.4 percent month-over-month in November after and upwardly revised 0.4 percent rise in October. The figures suggest that momentum is building in the fourth quarter, pointing to what may be the strongest Christmas selling season in four years.

Business inventories expanded 0.4 percent in October, but are still falling behind the growth in business sales. This will lead to accelerating growth and rising prices in the coming months.

The Federal Reserve and the Treasury have neglected the dollar this year. But the Fed will raise interest rates faster than current market expectations (favoring the dollar over the euro) while Japan will benefit from inflation in the U.S. (thus favoring the yen over the dollar).

The Fed has been in a “no confidence” position in which the dollar will weaken gradually when the central bank shows signs of delaying rate hikes. But in its meeting last week, the Fed shifted to an “almost neutral” inflation bias, which is a pleasing development. It’s a small first step toward rate hikes.

Still, there’s every reason to watch inflation closely these days. Import and export prices, the earliest official data on November inflation, rose well above expectations (0.4 percent and 0.5 percent month-over-month respectively). The Fed, meanwhile, remains massively stimulative. It is using the same backward-looking model that caused the 2000 deflation and ignored it. The Fed’s 1 percent target interest rate today is as erroneous as the 6.5 percent rate in 2000. The dollar is at its weakest point since 1987 relative to its 10-year average, and real interest rates are substantially more negative than in 1993.

It’s not only the Fed that is loose. The monetary stimulus covers Asia as well — with Japan, China, and many others trying to keep up with the U.S. in terms of expansionary monetary policy.

The bond and interest-rate futures markets are not good at anticipating the large rate hikes that should occur in 2004. Interest-rate futures routinely reflect interest-rate trends rather than anticipate future interest rates.

Currency markets, meanwhile, will be better at anticipating inflation. However, currency vigilantes do not have the stabilizing impact on inflation that bond vigilantes have, because a weaker currency does not slow the economy in the way higher yields do. This means there’s little check-and-balance when it comes to Fed decisions. In the past this has led to wide swings in interest rates when the Fed lags the inflation or deflation outlook.

And that’s a valid focus of concern these days. What’s not a concern is the economy — which appears to be firing on all pistons.

– David Malpass is the Chief Global Economist for Bear Stearns.