Perils of cooling a hot economy

It's been the million-dollar question of recent years: How much longer can America's golden economy last?

To push this record-setting economic expansion as far as possible, the Fed has carefully performed a high-wire act - balancing the benefits of low interest rates and full employment against the threat of renewed inflation.

Now, Alan Greenspan and the Federal Reserve Board, seeing signs that the US economy may be careening toward high inflation, will again try to slow things down without braking into a stall.

Already, indications are that it's getting harder to keep the right balance. If Mr. Greenspan and company opt to raise short-term interest rates on Aug. 24, their next meeting, it would be the second rate hike this summer - and could zap the important housing industry with a ferocious shock.

Already, rates for home mortgages have climbed above 8 percent for the first time in more than two years. The housing boom, a key factor in the nation's eight-year economic expansion, has been fueled by rock-bottom interest rates. If they continue to drift up, the end of both could be in sight.

"Certainly the housing industry is a key for the future, and that could slow down somewhat," says Texas A&M economist Nancy Granovsky.

She and other analysts, however, note that the US economy is still robust and that, because mortgage rates have already jumped in anticipation the Fed will again raise interest rates, homebuyers can expect the cost of borrowing to stay at current levels for at least a few months.

Moreover, the economy is expected to accelerate during the second half of the year. In the second quarter, the gross domestic product slowed to 2.3 percent. Economists are now looking for a pickup to about 3.5 percent, regardless of what the Fed does to interest rates through the end of the year, as businesses increase inventories to make up for empty shelves last quarter.

"We expect to see the economy continue strong and then drop off in the beginning of next year," says David Wyss, an economist with Standard & Poors-McGraw-Hill in Lexington, Mass.

If housing slows, consumer spending moderates, and business cuts its capital spending, the economy will slow to a 3 to 3.5 percent annual pace, says Bruce Steinberg, chief economist for Merrill Lynch & Co. in New York.

The latest evidence that the economy is sprinting came Friday, with news that the unemployment rate in July remained at 4.3 percent but that the economy created a whopping 310,000 jobs - far more than expected. Although the bulk of the new jobs is in services, such as retail clerks, some also came in the manufacturing sector, which has been losing jobs for the past year.

"The pace of job growth is unacceptable to the Fed," says Mr. Steinberg. "To avoid further action by the Fed after that, job growth must slow."

Economists know that Greenspan likes to look at one of the broader measures of unemployment - a gauge that measures those who are not officially in the labor force but would like to be. In the latest report, the jobless rate for this group dropped to 5.2 percent compared with 5.6 percent a year ago. "It indicates the reservists in the ranks of the unemployed are growing thinner," says Paul Kasriel, an economist with Northern Trust Co. in Chicago.

Greenspan is also likely to be unhappy over the pace of wage increases. The latest wage data indicate pay raises are up 3.8 percent over last year.

If the economy does not respond to another interest-rate hike, economists expect the Fed will raise rates when it meets again Oct. 5. "We are seeing more than one tightening in the market right now," says Kevin Flanagan, an economist with Dean Witter Morgan Stanley in New York.

Steinberg believes the housing sector is already responding to the rise in interest rates - and there is some evidence that home builders are starting to see a slight slackening in buying.

But analysts say that, while the heady days of mortgage rates lower than 7 percent may be over, 8 percent is not exactly cause for despair. "An 8 percent fixed-rate mortgage isn't the end of the world," says Keith Gumbinger, a vice president with HSH Associates, a financial publisher in Butler, N.J. "It's still better than half the weeks in this decade."

In fact, Americans so far have defied higher rates and continued on a homebuying spree. Existing home sales hit a record high in June of an annualized 5.5 million (although mortgage rates had not hit their current highs by then).

And new housing permits, a leading indicator, were up compared with the previous month, though they aren't growing as quickly as they once were.

Still, potential homebuyers are antsy. Jeff Bliss, a college administrator, hurried last month to make a deal on a new house in San Luis Obispo, Calif. If he had waited until now, the higher rate would have cost him an extra $21,000 over the next three decades.

On the front lines of the mortgage industry, things also look bleak. The market for refinancing mortgages has virtually evaporated in recent months, leaving loan agents to spend time at work playing computer games and checking sports scores on the Internet.

"It's a new world this year as opposed to last," says Michael Levine, a loan officer at Fleet Mortgage in West Hempstead, N.Y. A year ago he would handle seven or eight refinanced loans per week; now he's lucky to get one or two.

"It's definitely a case of affordability being squeezed," says Bill Cheney, chief economist for John Hancock in Boston.

But he adds: "The big caveat is that almost everybody has expected the housing boom to end for the last two or three years, and been wrong."

(c) Copyright 1999. The Christian Science Publishing Society