WASHINGTON - The U.S. economy is doing just fine, thank you, and that is definitely a problem for the bond market despite five moves this year by the Federal Reserve to tighten credit.
The Commerce Department reported last week that U.S. output of goods and services in the second quarter grew 4.1%, puffed up by the biggest buildup of business inventories in six and a half years. Sales of new single-family homes jumped 9.7% in August to 703,000, the highest level in five months.
Analysts insist that the housing market is slowing down from the hot pace of late last year. Mortgage loan volume is falling, and mortgage interest rates hit a two-year high last week as the average 30-year fixed-rate mortgage climbed to 8.82%.
The problem for the bond market and for Fed policymakers is that the economy is not slowing down enough to fend off worries about an upturn in inflation, which everyone still believes is going to come around the corner like an unfriendly street beggar.
Most analysts say that over the long haul the economy cannot grow faster than 2.5% without stirring up inflation, and that is the pace of growth that Fed officials are believed to be looking for in 1995. While things are cooling a little compared with the first half of the year, few believe the magic rate of 2.5% is locked in yet.
Accordingly, there is widespread belief in the markets that more Fed rate increases are in store. Lyle Gramley, consulting economist to the Mortgage Bankers Association, predicts that the economy will close out the last three months of the year by growing a hearty 3.5%. Gramley, a former member of the Fed, says the central bank's next widely expected rate increase will not be the last. He predicts that the central bank will raise short-term rates to 6.25% by early next year, up from the current 4.75%. Other economists agree.
It wasn't supposed to work out this way. A year ago Wall Street was predicting a gentle rise in rates as the economy slowed to a comfortable but sustainable pace.
"The economy is always more resilient than you think, and generally interest rates have to go up more than you anticipate," says Darwin Beck, a managing director at CS First Boston.
The irony in all this is that inflation still has not reared its ugly head, despite a few scares along the way. Analysts says falling oil prices will produce tame inflation reports for September when they are released later this month.
Despite disclaimers from Fed officials that they are not targeting growth, they have made clear that they feel uncomfortable with an economy that is now close to capacity and moving ahead under a full head of steam.
Fed chairman Alan Greenspan and his colleagues have defended their policy of raising rates as a "neutral" one aimed at removing unnecessary stimulus to the economy and preempting inflation. But the next time they act, they will plainly be tapping on the brakes.
It remains, to be seen if they get it right. While forecasts for a happy landing with moderate economic growth in 1995 are common, this year's rate increases, and those to come, may take over a year to hit home to consumers and business.