July 19, 2004
by Irwin Stelzer
Game, point and possibly even match to Fed Chairman Alan Greenspan. When he and his monetary policy committee raised interest rates by only 0.25% a few weeks ago, the inflation hawks were out in force. The economy, they said, was overheating, and the Fed chairman, wedded to the view that rising productivity would keep costs and prices under control, was refusing to take the vigorous action necessary to head off an impending inflationary surge. Rates should have been raised sooner and faster, they argued.
It turns out that Greenspan had it right. Late last week the government reported the largest drop in wholesale prices in a year, with energy and food leading the declines at 1.6% and 0.6%, respectively. Excluding those volatile elements, "core" wholesale prices rose only a modest 0.2% in June. Consumer prices also showed no signs of the inflation that so worries the hawks: core inflation rose a tiny 0.1%.
Further support for Greenspan's refusal to panic and raise rates came from news that industrial production fell 0.3% in June, that the capacity utilization rate dropped from 77.6% in May to 77.2% in June, and that retail sales fell by 1.1% last month, the largest monthly drop in 16 months, pulled down by a 4.7% plunge in auto sales.
None of this necessarily means that the economy is stalling: despite the June drops, sales and production were up 6.3% and 5.6%, respectively, year-on-year. Even the pessimists are expecting growth to come in at 3.5% in the second half of the year. In addition to the fact that one month's data do not make a trend, especially when we are dealing with highly volatile series, there are signs that the recovery still has strong legs.
Both the Philadelphia and New York factory indexes rose sharply this month, leading David Heuther, chief economist at the National Association of Manufacturers to exult, "Manufacturers are experiencing the best times they have had in five years." And corporations are awash in cash. BusinessWeek reports that at the end of the first quarter its sample of 374 of the 500 companies in the Standard & Poor's Index of share prices were holding $555.6 billion of cash and short-term investments, $56 billion more than they were sitting on at the end of last year, and double what they had at the end of 1999.
Two factors suggest that these companies will start to whittle down their cash hoards in the second half of the year. The first is the mounting optimism of the nation's CEOs. The Conference Board reports that more than 90% of these corporate heads believe the economy has improved. The second reason that corporations are likely to dip into their cash is that they will want to avail themselves of the depreciation allowances that will expire at year-end. Why put off until next year what you can save money by spending now?
Add optimistic reports from Dell, IBM and other hardware manufacturers, and complaints from trucking firms that they can't find enough drivers to handle the increasing demand, and you hardly have a picture of unrelieved gloom in the sector.
There are also some encouraging signs on the consumer side. The economy continues to create jobs, although perhaps -- only "perhaps" -- more slowly than in the first quarter. Gasoline prices, which have hit the pocketbooks of customers of Wal-Mart and other mass marketers, have eased from their late May peak of $2.05 to $1.90 per gallon for self-serve regular grade.
Most important, despite rising interest rates, the housing market remains in good health, with sales of new homes in May hitting a record. The National Association of Realtors' Housing Affordability Index shows that a family with a median income of $55,000 can easily afford the median-priced existing home, which sells for $184,000.
So should all of the recent bad news be dismissed as a one-month blip? Perhaps, but not certainly. Take the housing market. With interest rates rising, heavily leveraged consumers might have to cut back on other purchases, especially the house wares and appliances that were the bright spots June's retail sales figure. Faced with higher interest rates, many new homebuyers would find themselves unable to afford current prices. Estimates are that prices have to come down about 10% to offset the increased carry cost associated with a one-percentage point increase in mortgage rates.
Or consider the relatively benign inflation picture painted by the just-issued producer and consumer price indices. If prices continue to weaken, or at least not rise very much, the Fed can go slow-and-easy on interest rate increases, or even skip one or two. But after falling during the spring, commodities prices have started to rise. The prices of nickel, cement, steel, aluminum, asphalt and coal are ticking up, perhaps because China's economy continues to expand at a close to double-digit rate. That means that bids for construction jobs will rise, as will housing and other costs.
If all of that doesn't cloud your crystal ball, consider this. The price of oil remains at the mercy of terrorists, who have proved they can easily disrupt shipments from Iraq, and are now threatening the stability of Saudi Arabia. Worse still, with the Democratic and Republican conventions this month and next, and the presidential and congressional elections set for November, America is now at the top al Qaeda's list of targets. The terrorists would like nothing better than to disrupt -- or, at minimum, influence -- the American elections, as they did in Spain.
So it is sensible for Greenspan to be less certain about the outlook than his critics. And wise to risk a bit of inflation by raising rates a bit too slowly, rather than risk a recession by raising them too quickly.
A version of this appeared in The Sunday Times (London).
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.
Home | Learn About Hudson | Hudson Scholars | Find an Expert | Support Hudson | Contact Information | Site Map
Policy Centers | Research Areas | Publications & Op-Eds | Hudson Bookstore
Hudson Institute, Inc. 1015 15th Street, N.W. 6th Floor Washington, DC 20005
Phone: 202.974.2400 Fax: 202.974.2410 Email the Webmaster
© Copyright 2013 Hudson Institute, Inc.