Not The Stuff of Slowdowns
Discussion of an economic blast-off would be more appropriate.


David Malpass

The U.S. will probably grow more in the second half of 2004 than in the first, once again answering any skepticism about the expansion. We’ve been down this road before. The slowdown predictions of September 2003 related to slower mortgage refinancings and the expiration of the tax rebates. The slowdown predictions of February 2003 related to excess capacity and weakness in the payroll employment survey. The economic reality, however, has been one of very fast growth rates — driven by consumer resilience and the business sector.

A visitor from Mars would be surprised by talk of an economic slowdown. In fact, given the circumstances, he would probably think a discussion of an economic blast-off more appropriate.

The foundations for fast economic growth are in place in the U.S. These include a reasonably valued dollar, strengthening growth abroad, robust small-business profits, the 2003 Bush tax cut on capital and labor, and a 5.5 percent unemployment rate. Profit growth, corporate cash accumulation, and small-business income have all been strong. Meanwhile, inventories are low in both the U.S. and other developed countries.

This is not the stuff of slowdowns.

Real interest rates are negative, indicating a very loose monetary policy from the Federal Reserve. In effect, the Fed has begun to remove pressure from the pedal-to-the-metal accelerator, yet with no thought (so far) of hitting the brakes. The monetary stimulus is global. Overnight interest rates are at 1.5 percent in the U.S., 0 percent in Japan, and 2 percent in Europe (versus the 4.75 percent benchmark rate in England under similar circumstances). Adding further stimulus, fast-growing China’s monetary policy is loosely linked to the expansionary U.S. monetary policy through its currency peg.

Manufacturing also points to economic strength rather than weakness. The Institute for Supply Management’s index typically declines well ahead of broader economic weakness. But the ISM index has been above 60 for nine consecutive months. This hasn’t happened in twenty years. According to the ISM, the current level of its index is consistent with GDP growth near 7 percent. Further brightening the manufacturing picture, job growth in the sector has strengthened substantially.

Of course, equity markets were weak for several months after the Fed shifted to a measured rate-hike policy. This year’s stock market weakness has also reflected a letdown from equity strength in 2003, concerns about expensive oil, and election uncertainty. However, while stock prices are an important leading indicator of the economy, equity declines have historically occurred much more frequently than economic slowdowns. This is probably the case once again.

Other market-based indicators are signaling economic strength ahead. Credit spreads (the difference between the interest rates corporations pay and those the federal government pays) remain very tight, signaling a strong economy rather than a weak one. The prices of industrial materials are rising, a reflection of stimulative monetary policy and strong global growth. The Treasury yield curve is currently at near-record steepness (that is, the current 10-year yield far exceeds the current 1-year yield). This usually signals economic strength.

The U.S. economy is likely in the early stages of a multi-year expansion, one that will be characterized by strong domestic and global growth, higher interest rates, and a mild but persistent inflation problem. While expensive oil, corporate caution, and equity-market declines may cause drags, the expansion is strong enough to outlast them.

– David Malpass is the chief economist for Bear Stearns.