Buoyant Economy Just Will Not Slow

NEXT: HIGHER INTEREST RATES?

Get out the tickets: The US economy has revved well past the Federal Reserve's speed limit.

In the first three months of the year, US economic growth surged at an annual rate of 5.6 percent, driven by business and consumer spending. It represents the fastest rate of growth since 1987, when Ronald Reagan was president and Wall Street was the marquee movie.

The more buoyant economy has contributed to a drop in the nation's unemployment rate and a substantial lowering of the federal budget deficit, as tax revenues have grown.

Yet, even though there are signs the economy is already beginning to slow from the torrid first-quarter pace, most economists expect the Fed to raise interest rates on May 20, the next meeting of its rate-setting governors. This would be the second consecutive interest rate hike by the Fed, which boosted rates by 0.25 percent on March 25.

"All of the tightening is preemptive because there is still no sign of inflation yet," says Ram Bhatavatula, a senior economist at Citibank in New York.

On Wall Street, the immediate reaction to the robust report on the nation's gross domestic product (GDP) was negative, but by noon the Dow Jones industrial average was up, following a historic gain of 179 points on Tuesday. That climb was precipitated by a government report showing only small increases in labor costs in the first quarter.

Economists say a modest interest-rate hike would have only a minor direct effect on the economy - probably reducing economic activity by 0.1 or 0.2 percentage points. Yet it would have a broader impact on consumer confidence.

"Consumers don't like rate increases because they have a lot of debt, so it has an indirect psychological effect," says Christopher Low, an economist at New York-based HSBC Markets Inc.

Effects of last interest-rate hike

There are already some signs that the Fed's last interest-rate hike is having some effect. On Tuesday, the Conference Board reported its consumer confidence index fell slightly from its very high level.

The government reported, too, that March orders for durable goods also dipped.

A less hectic economic pace would coincide with most economic forecasts. In the current quarter, economists are expecting growth to slow to a 2.5 percent annual rate. "Rarely has one seen consumer spending as robust as this for more than two quarters," says Cheryl Katz, a senior economist at Merrill Lynch & Co in New York. In the fourth quarter of 1996, the economy grew above trend at a 3.8 percent annual rate.

Economists will be watching for signs of slower consumer activity today, when automakers report April sales. Initial expectations are for a slowdown in the salesrooms. The National Association of Purchasing Managers also releases its closely watched index today, which is expected to show a decline in activity because inventories rose sharply in the first quarter. This often portends slower activity later.

Economists will get an even better idea if the economy is slowing down tomorrow, when the Labor Department releases the employment report for April. Wall Street economists expect the nation's jobless rate to drop to 5.1 percent, its lowest level since 1989.

Even though joblessness is expected to fall, the number of Americans finding new jobs is also expected to slow down. This is a key economic number, because it gives a good snapshot of the economy.

When will the Fed stop tightening rates?

If the economy does start to lose steam, some economists believe the Fed might not have to tighten interest rates after May 20. "If the second quarter is weaker, they may be done tightening after May," says Mr. Bhatavatula.

But economist Henry Kaufman, who often has a gloomier view of interest rates, believes the Fed will crank rates up another 0.5 to 0.75 percent by the end of the year. "US official interest rates will have to move considerably above present levels in order to engineer a downshift in the tempo of growth sufficient to avert a sharp acceleration in the rate of inflation," says Mr. Kaufman, who heads up his own firm.

If the Federal Reserve does continue to raise interest rates, one of the largest effects will be on the housing market. In April, the nail guns were operating at high speed. David Lereah, chief economist for the Washington-based Mortgage Bankers Association, figures that every 0.25-point rise in rates eliminates 50,000 borrowers who no longer qualify for mortgages. He expects a slowdown to begin in June and July.

With mortgage rates currently about 8.1 percent, the payment on a $100,000 fixed-rate, 30-year loan will rise by $18 per month if the Fed raises rates. Although this may not sound like much, over the life of the loan the increase totals $6,480.

In expectation that the Fed would raise interest rates in March, there was a big rush to take out mortgages. "They guessed right so far," says Mr. Lereah.