It's a Jekyll and Hyde Economy- And a Slump May Be Result

The nation's dynamic economy seems to be moving in two opposite directions. And at some point, something has to give, several economists warn.

"Demand is generally strong, while production is faltering. This cannot continue indefinitely," said Bruce Steinberg, chief economist at Merrill Lynch & Co., who calls it "the two-headed economy."

Economist and money manager A. Gary Shilling first noted what he labeled "the two-tier economy" last summer. He thinks a recession may be the ultimate outcome.

Fresh data last week, notably the latest employment report, underscored the unusual trends.

Reflecting the strong housing and consumer sectors, 378,000 new jobs were created in December and the unemployment rate declined to 4.3% from 4.4% in November. The figures much exceeded the expectations of most economists.

But the manufacturing sector is still shrinking. The latest National Association of Purchasing Managers index was significantly weaker than expected, falling to 45.1 in November from 46.8 in October, its lowest level since May 1991. A reading below 50 signifies economic contraction.

Also weaker than expected was the NAPM nonmanufacturing index, which fell to 49.5 in December. It was the first time this new index, initiated in mid-1997, has fallen below 50. Mr. Steinberg said this suggests that "the faltering manufacturing sector is depressing activity in the service sector of the economy."

But on the demand side of the economy, the all-important housing sector is booming. November new-home sales advanced 7.6%, to a 965,000 annual rate, up from a revised 897,000 annual rate in October and surpassing the record set last June.

Lower interest rates, strong income growth, and the resilient stock market are the big reasons. "The underlying strength of demand can be seen in all its glory," said Ian Shepardson of High Frequency Economics, Valhalla, N.Y.

In fact, Mr. Shepardson said, he thinks the economy is currently growing at a robust 5.5% annual rate and will expand 2.7% this year, versus 3.7% last year. He said the Federal Reserve may even have to consider raising interest rates.

The more cautious Mr. Steinberg last week raised his own growth forecast by half a percentage point, to 2.5% at an annual rate for the current quarter and 2% for the year. He said he still thinks, however, that the Fed is likely to reduce rates again as economic weakness appears later in the year.

As Mr. Shilling sees it, the impact of economic weakness in Asia and elsewhere abroad is driving both levels of the two-tier economy.

The top tier-consumer, housing, and capital equipment sectors-"has benefited from Asia's downward pressure on prices as well as soaring stocks," he said. But the same Asian-generated deflationary pressure has steadily weakened the second tier-manufacturing industries, which have seen product demand and pricing power eroded.

Mr. Shilling, who heads his own firm in Springfield, N.J., said he thinks the two-tier economy is unsustainable for long and that the consumer-led upper tier must ultimately be pulled toward the weaker lower tier as the economy heads toward recession, perhaps beginning this year.

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