Economy wobbles under cost of oil

Higher energy prices are starting to slow the US economy.

While economists have predicted such an effect for months, it's finally here - evident in lower retail sales, growing inventories of cars, and fewer new jobs.

In the second quarter, economic growth is expected to slow from last quarter's rambunctious 4-plus percent to closer to 3 percent. The slower growth probably means the Federal Reserve Board, which has hiked interest rates by a quarter point seven consecutive times, may begin to think about backing off perhaps as early as June.

Unfortunately, a slower economy also has other ramifications. There could be fewer jobs created in the future, business may hold off on new investments, and uncertainty about the economy may cause consumers to curb buying even more.

"Right now we don't know the magnitude of the slowdown," says John Silvia, chief economist at Wachovia Corporation in Charlotte, N.C. "But I'm from New England and when a strange wind comes up, you take notice of it."

Over the past several weeks, the financial markets in particular have certainly had the wind knocked out of them. Since March 4, the Standard & Poor's 500 index is down almost 6 percent. Last Friday, the stock market was particularly battered, with the S&P index off 19.43 or 1.67 percent and the Dow Jones Industrial Average down 191.24. For the week, Wall Street suffered its worst loss in two years.

"It appears investors are now readjusting some of their expectations, and maybe the economy is likely to hit a soft patch because of higher energy prices and their affect on consumer spending and corporate earnings," says Sam Stovall, chief investment strategist at Standard & Poor's.

Indeed, the higher energy prices have caused many economists to downsize their growth forecasts for 2005. Mickey Levy, chief economist at the Bank of America, last week lowered his projection for the second quarter by about 0.5 percentage points, which translates into about $50 billion. "The higher oil prices operate like a tax on the consumer," says Mr. Levy.

He expects the softness in the economy to continue through September before it starts to get stronger. "The economy has the flexibility to absorb shocks and continue to expand," he reasons.

The slower economic pace suggests the labor market will be disappointing. If the gross domestic product grows at 3 percent, the economy will create just enough jobs for people entering the workforce. Business will be able to fill orders without the need to expand. "It becomes a let's wait-and-see type of attitude by business," says Mr. Silvia.

Soft spots are not unusual during an economic expansion. For example, during the recovery of 2002-2003, there were times when the economy built up strength and then softened again. In 1995, after the Federal Reserve hikes of the prior year, the economy had some difficult months.

Despite the slowdown, analysts believe the economy is still fundamentally sound. Inflation, despite some recent increases because of energy costs, is not deeply entrenched. Corporate profits and balance sheets are relatively strong. Interest rates, though rising, are still historically low. And business appears to be optimistic enough to spend money on capital expansion.

"Unless data comes in that is decisive and shows the economy is turning around, you can argue the fundamentals are quite sound," says Lyle Gramley, a consulting economist at the Schwab Washington Group and a former Fed governor.

Still, the sharply rising price of gasoline - up about 40 cents a gallon over last year - seems to have taken a toll on consumers. Last week, the Commerce Department reported retail sales rose only 0.3 percent in March, half of what Wall Street had expected.

The wetter weather didn't help: Sales of apparel in department stores were particularly weak. To economists, the weak retail sales indicate pump prices, now averaging about $2.26 a gallon nationally, are starting to reduce disposable income.

"There is a cumulative impact on consumers' budgets and a more significant impact on their spending decisions," says Richard Curtin, director of the University of Michigan survey of consumers.

For example, in March, Mr. Curtin says consumers turned more negative about buying automobiles than household durables. Much of that is because of the rising gasoline prices.

"If you're buying a vehicle today, you are making a bet on the price of gasoline over the next four to five years," says Curtin.

But, he adds, the auto companies, because of their own financial problems, are also offering smaller discounts.

When it meets early next month, the Federal Reserve will debate how long the softness is likely to continue. "It could be one to two months or it could be longer," says Mr. Gramley. "That uncertainty affects Fed policy."

Despite the apparent slowdown in the economy, Gramley expects the Fed will still raise rates 1/4 of a percentage point in May. Yet it's now doubtful the central bank will hike rates by a 1/2 percent as some had expected. By June, "there will be a lot more information about what's really going on," says Gramley.