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Economy shows strength; forecasters see risks

Despite Friday’s strong employment report and other data showing a strong economy,  skeptical Wall Street types still find plenty to worry about, from rising interest rates to the prospect of a suddenly collapsing housing bubble.
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Friday’s strong employment report reinforces the increasingly accepted view of an  economy humming along nicely in its fourth year of expansion, growing faster than many analysts had forecast even just a few weeks ago. But even as they raise their growth projections, skeptical Wall Street types still find plenty to worry about, from rising interest rates to the prospect of a suddenly collapsing housing bubble.

On the surface, it would appear things are going rather well, with employers adding jobs at a solid rate of 175,000 a month so far this year, pushing the unemployment rate down to 5 percent, its lowest level in four years.

The stock market, moving ahead in fits and starts, has gained about 9 percent over the past five months, edging upward to levels last seen in 2001. Despite surging oil prices, inflation appears to be well under control. Strong tax revenues mean the federal budget deficit for the current fiscal year is likely to be much smaller than previously projected.

Federal Reserve Chairman Alan Greenspan and his colleagues are universally expected to raise interest rates another quarter-point when they meet Tuesday and have no reason yet to pause in the year-old rate-tightening cycle.

“I think what has happened is we have had another one of these ‘soft patch’ scares, and the data have pretty convincingly rejected the idea that there is any sustained slowing,” said Ethan Harris, chief U.S. economist at Lehman Bros.

Last week’s preliminary report on second-quarter growth sent Harris and many other forecasters scurrying to their spreadsheets to boost projections for the second half.

Although the economy expanded in the quarter at a moderate 3.4 percent rate, the report showed a surprising decline in available inventories of manufactured products like automobiles. That implies factories are likely to ramp up production in the months ahead to replenish  supplies, boosting economic output.

As a result, forecasters are now calling for a growth rate of up to 5 percent in the current quarter, which would be the best showing in two years.

But that is where many economists turn cautious and warn of risks that make it unlikely that strong pace of growth can be sustained.

Harris, of Lehman Bros., is typical. He raised his projection for second-half growth Friday to 4 percent from 3.5 percent but is calling for a fairly sharp slowdown next year to a subpar rate of 2.5 percent. One main reason: He sees a “significant” risk that the housing market will cool substantially.

“The result is likely to be a significant slowing of growth in 2006, a slowdown that would likely force the Fed to lower rates by year-end,” he said in a note unveiling his new forecast.

The risk of a sharp slowdown in housing activity crops up repeatedly when economists talk about the prospects for the year ahead. Surging home prices – up more than 12 percent year-on-year – have been feeding through to the economy several ways, including a psychological wealth effect that encourages consumers to spend more because their homes are worth so much more.

“Obviously it helps consumer spending enormously,” said Hugh Johnson, chairman of Johnson Illington Advisors. Many homeowners have been taking equity out of their homes and spending it by taking out home equity loans or simply assuming bigger mortgages when they move up to a larger house, he noted. “It has been an important part of growth, and that is another reason to worry,” he said.

The normally optimistic Johnson published a note this week suggesting that the housing bubble may have peaked despite last week’s data showing a record sales pace and a sharp increase in existing-home prices. Johnson noted that the median price for new homes has been rising this year at a rate of a bit more than 5 percent, compared with more than 15 percent for much of last year.

“It may very well be the case that speculators are beginning to have difficulty selling higher-priced homes and banks are beginning to back away from financing speculation in higher-priced homes,” he said.

So far, he said, it appears the air is coming out of the housing bubble gradually. “It is, however, too soon to dismiss the risk of a sharp decline in prices as speculators race for the exits,” he said.

There are other risks to the outlook, too.

One is the national savings rate, which has dropped to zero, the lowest October 2001, when the rate briefly turned negative. That means much of this year’s strong spending has been fueled by consumers draining their savings, which eventually will need to be replenished.

Consumers seem to be weathering the high price of oil, but analysts still worry that it could work its way further into the economy in the form of high inflation.

And the Fed itself poses a risk as the steady drip of higher interest rates is bound to take a toll on economic growth.

The Fed’s expected rate hike Tuesday will be the 10th in 14 months, bringing the overnight federal funds rate to 3.5 percent, compared with 1 percent when the cycle began last year. The risk that the Fed could overdo the rate-hike cycle and possibly send the economy into recession was the No. 1 worry mentioned in a quarterly survey of investment managers at Russell Investment Group, said Noel Lamb chief investment officer for the Tacoma, Wash.-based firm.

“Higher short-term rates mean consumers face higher amounts on such payments as adjustable-rate mortgages and credit cards, leaving them with less discretionary cash, which, in turn, could dent both the housing market and corporate revenues,” he said in a commentary.

And while the latest batch of data has boosted the consensus forecast for the second half of the year, not everyone is a believer.

Much of the inventory decline in recent months stems from aggressive incentives offered on U.S.-made cars, creating sales spikes that seem unlikely to be repeated.

“We’re not getting carried away,” said John Silvia, chief economist for Wachovia Securities. He is still calling for growth of 3 to 3.5 percent in the second half of the year, in line with the economy’s long-term growth rate.

“I think the inventory gains are going to be more modest than what is expected,” he said.

Silvia pointed out that there are no visible catalysts for a reacceleration of economic growth. No major tax cuts are in sight, energy prices appear unlikely to drop sharply and the Fed is taking away stimulus rather than adding it.

David Rosenberg, chief North American economist of Merrill Lynch, said the Fed’s rate tightening cycles have always managed to “expose and purge the excesses of the day,” and likely will do the same in areas where housing is overheated.

The lags between when rates are raised and when their impact is fully felt in the economy are “long, variable and insidious,” he said. “Maybe we won’t see it until next year,” he said. “It’s just a matter of time.”