05/ 30/ 2007
by Bill Dunkelberg
Charting a course with mixed signals
The economic signals are becoming more confusing. Recent reports show inflation advancing at a pace that in the long haul is unacceptable. But if we exclude rising food and energy costs and look at so-called core inflation, the annual rate of increase is much lower--still too high but by less than a percentage point. So, do we have a problem with inflation or not? The core rate is not too bad, but headline inflation is what we pay, and it is high. So, should the Fed raise rates or hold tight? The NFIB survey data hasn't provided a lot of promise for getting inflation under control. The net percent of firms raising average selling prices has increased from 8 percent in December 2006 to 15 percent in the first quarter of 2007. Inflation won't fall to 2 percent with this many firms raising prices.
Slow But Sure Growth
The economy seems to be growing slowly, but not fast enough to keep up with the growth in our potential output. Business spending is weak, and housing is on the ropes. NFIB's Index of Small Business Optimism has been slipping and has been below the 30-year average for most of the past 12 months. Fewer owners expect sales to increase, and more owners expect the economy to slow rather than pick up speed. The index isn't in recession territory, but it signals weaker growth, likely below 2.5 percent. This weak growth usually means that unemployment should be rising, and the Fed should consider cutting rates to spur the economy and housing in particular. But unemployment has been falling; the unemployment rate is about as low as we can expect it to go. Labor markets are tight, and compensation is rising. One in four owners are reporting job openings they can't fill. And more than one in 10 plan to increase employment at their firms. Nearly a third of business owners are reporting higher worker compensation (but only half as many are raising prices to pass these costs along to customers). These trends might suggest a rate hike to combat inflation.
Spending Spree Continues
Even though the economy has slowed substantially, consumers continue to spend more than they earn. This negative saving rate has helped propel the economy forward, but observers wonder just when the consumer will run out of powder. House prices have stopped rising and are falling in many markets, so consumers have less home equity to tap to support spending. But, just when it seemed like the equity-based spending spree might end, along comes another record stock market to inflate consumer wealth and support spending. But this stock-market run is different: It isn't driven by earnings improvements. Earnings peaked last year at a record percent of GDP. This time, share prices are advancing because firms, flush with profits and cash, are buying back shares instead of investing in their companies. Capital spending has been very flat in the NFIB survey; there was no increase in spending that one might expect with strong profits. And private-equity firms paid nearly half a trillion dollars in 2006 to take firms private. Their stock has disappeared from the stock market. This practice is producing a fragile market whose valuation, sooner or later, will have to align with the fundamentals of lower profits and rising interest rates.
So, the Fed's dilemma reflects the mixed signals being sent by the economy. It's looking like "Stagflation" with a small "s." A recession seems unlikely, but--like a bicycle--the slower you go, the more likely you are to be tipped over by a gust of ill wind.
