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Bumps remain on economy's road to recovery

The U.S. economy is picking up speed on the road to recovery. But there are still plenty of bumps and potholes ahead.

The U.S. economy is picking up speed on the road to recovery. Mind the bumps and potholes, though.

Fueled by strong demand for U.S. exports, a rebound in household spending and growing confidence among businesses and consumers, the U.S. economy posted solid growth in the last three months of the year, the government reported Friday.

The economy grew at a 3.2 percent annual rate, the Commerce Department said, after expanding at a 2.6 percent pace in the third quarter. The rise was a touch below economists' expectations for a 3.5 percent rate.

Consumer spending, which accounts for more than two-thirds of U.S. economic activity, grew at a 4.4 percent rate — the fastest pace since the first quarter of 2006. Strong growth in exports also helped the recovery gain momentum.

Consumer sentiment also improved in late January, according to a survey released Friday. Expectations of more cash to spend due to federal tax cut extensions and a temporary reduction on payroll taxes brightened consumers' mood, the latest consumer survey from Thomson Reuters and the University of Michigan showed.

The growth is also showing up in the latest round of quarterly corporate profit reports, which are coming in stronger than expected. Of the about one-third of companies on the Standard & Poor's 500 index that have reported quarterly earnings so far, almost 70 percent have beaten estimates tracked by Thomson Reuters.

Rail giant CSX Corp., for example, this week beat estimates and forecast record profits for 2011. The company said it plans to boost capital spending to keep up with growing demand, especially for coal exports to emerging countries such as China and India.

"We're seeing continued strength in the economy," CEO Michael Ward told Reuters. "We're feeling it's not anything dramatic, but it's going to be a continual gradual recovery that we've seen the last six or seven quarters."

Stronger corporate profits have also boosted stock prices, along with a massive infusion of cash from the Federal Reserve, which is spending hundreds of billions of freshly created dollars to buy Treasury bonds and keep interest rates low.

Lower interest rates spur the economy by helping businesses borrow money, expand operations and hire more workers. But the Fed is also hoping that higher stock prices will add wealth to American households and help support consumer spending, further spurring growth.

The hope is that the momentum in stock prices continues to create wealth, prompting more spending and creating more demand that boosts economic activity and drives corporate profits higher still.

Fed officials on Wednesday renewed their pledge to keep the cash flowing, buying bonds to keep interest rates low. Those low rates have prompted investors to seek higher returns in stocks, which are a riskier bet — and the dividends they pay have been funded by rising profits.

After its regular rate-setting meeting Wednesday the Fed’s Open Market Committee said  it would stick with its plan to buy $600 billion of Treasury bonds through the middle of this year. The target for its short-term federal funds lending rate will remain at less than 0.25 percent, and rates will stay “exceptionally low” for an “extended period,” policymakers said.

The flow of all that cash into the stock market is no accident.

“(Fed) policies have contributed to a stronger stock market just as they did in March of 2009 when we did the last iteration of this,” Fed Chairman Ben Bernanke recently told CNBC. “The Standard and Poor’s 500 is up about 20 percent plus and the Russell 2000 ... is up 30 percent plus.”

So as long as the Fed maintains its bond buying spree, investors will likely continue to buy stocks.

“When the chairman of the Federal Reserve says he wants share prices higher, and he's going to pledge $600 billion of money where his mouth is, you don’t fight that,” said Michael Farr.

By any measure, the latest stock market rally is one of the strongest on record. As measured by the S&P 500 index, the stock market has nearly doubled from a low of 683 in March, 2009. That’s one reason some market watchers think it may be time for stocks to take a breather.

“We might go down 5 percent,” said Tobias Lefkowitz, Citibank’s investment strategist, who thinks the S&P 500 index will hit 1440 before year-end. “But that's normal. And we should expect that. Nothing goes up in a straight line.”

To keep U.S. GDP and stock prices rising, companies are going to have to keep posting higher profits — which may get tougher to come by. Part of the reason profits are up is that they were badly battered by the recession. As those comparisons fade into history, it could get tougher to maintain double digit earnings growth.

“Now it's back to reality,” said San Diego-based investment manager Harry Rady. “Now companies are going to really have to work to hit the numbers. All the cost cutting is behind them. All the easy (comparisons) are behind them. And, frankly competition is fierce.”

Stimulus fades
Growth in corporate profits will also depend on the economic recovery continuing to pick up speed as the impact begins to fade from the government's massive stimulus spending program and payroll tax cuts. Farr is among those who say the jury is still out on whether the economic recovery is self-sustaining.

“When you’ve got a (Gross Domestic Product) that’s two-thirds consumer, I see lots of headwinds there,” Farr said, citing a 9.5 percent unemployment rate.

The GDP rebound also comes as the Obama administration’s efforts to boost growth begin to take hold. The hundreds of billions of stimulus spending flowing through the economy will be replaced this year by payroll tax cuts that will put more money back into consumers' pocketbooks. The hope is that those stimulus programs generate enough forward momentum to keep the economy growing after those programs expire.

They could also leave the U.S. economy with a major hangover as the government cuts spending to reduce the federal deficit, according to the latest estimates from the Congressional Budget Office. Gaping budget shortfalls have already forced many states to make deep cuts in services and continue to cut workers.

Friday's GDP showed that government spending shrank in the latest quarter, with much of the drag coming from state and local governments

To be sure, the economic recovery has done little to revive the job and housing markets. Home prices are still falling. And though sales have perked up they remain at recessionary levels. Analysts expect the January employment report to show a gain of about 125,000 net new jobs: barely enough to keep up with the growth in the work force.

More headwinds
Further headwinds to the U.S. economy could come from forces outside the control of U.S. policymakers. While the U.S. central bank is adding cash aggressively to the global financial system, central bankers elsewhere in the world are keeping a wary eye on a jump in commodity prices that have fueled inflation worries around the globe. European Central Bank President Jean-Claude Trichet has warned they present a threat.

“Their mandate (in Europe) is against an inflation target first,” said David Kotok, chief investment officer at Cumberland Advisors. “In Europe they will take a 10 percent unemployment rate and tighten policy. In the United States we won't. That's the difference between the two banks.”

China’s government has recently ordered banks to curb the growth of credit to slow inflation, prompting a big jump in interest rates. State-run media Tuesday reported that some banks are setting rates 45 percent higher than the benchmark of 5.81 percent for one-year loans.

Tighter credit in emerging economies could slow a major source of profit growth for companies with a large presence overseas.

While the Fed has committed to continue pumping out fresh cash through this summer, the central bank will eventually have to stop the printing press. When it does, it’s not at all clear how the stock market will respond.

“A lot of what's going on has to do with the Fed's distortion of stocks with (easy money policy) and a lot of cash,” said Barry Ritholtz , director of research at Fusion IQ. “I know they're trying to keep the bogeyman at bay but there will be repercussions and when that (policy) goes away. It's not likely to go away smoothly and easily. It's likely to be a dislocation.”