Economic Ups and Downs

Growth keeps chugging along, but inflation is the threat to watch.

Wall Street Journal
Saturday, April 28, 2007 12:01 a.m.

Investors and the statisticians sent seemingly contradictory messages this week, with the Dow Jones Industrial Average hitting new highs and breaking past 13,000, while GDP growth for the first quarter came in at 1.3%, its lowest level since before the 2003 tax cuts. So whom do you believe?

The stock market is hardly a perfect predictor of the future, and the recent upward trend could reverse itself at any time. But the market is, as the old adage goes, a mechanism for discounting the future, while statistics like Friday's GDP estimate are calculations about the past. So if we had to choose between the two conflicting signals, we'd put our money on the collective sense of the market, which these days is saying that the economy is stronger than the conventional wisdom would have you think.

The housing slump has undeniably taken its toll on overall growth for the past three quarters, and that continued in the first quarter of this year. For the quarter, the decline in residential investment shaved about one percentage point off GDP growth.

The good news is that the housing slump shows no signs of tanking the larger economy. Unemployment remains low, at 4.4%, and wages are rising amid an overall very tight labor market, especially for skilled workers. This wage growth in turn is helping consumer spending, which continues to increase despite rising gas prices. Hidden beneath Friday's disappointing headline growth number of 1.3% was 3.8% growth in consumer spending on an annual basis. That's none too shabby, given that home-equity extraction has dropped precipitously with rising interest rates and falling home prices.

Corporate profits, meanwhile, continue to come in ahead of expectations, even though profit growth will likely come out slower in the first quarter than the double-digit rates of recent years. Trade also knocked first-quarter GDP down by about 0.52%, as exports declined and imports rose. Rising imports are a sign of strong domestic growth, and we doubt exports will keep falling given buoyant growth overseas. Trade figures are a part of the GDP report often subject to revision, and that could make the quarter look better in future weeks.


If there's a real red flag in yesterday's economic data, it's the inflation numbers. The personal-consumption expenditures deflator--the inflation measure used to derive real economic growth from the nominal figure--rose at a 3.4% rate in the first quarter. The "core" number, which excludes food and energy prices, rose by 2.2%, still above the Federal Reserve's comfort range. The core number has now been above 2% for more than a year, and the inflation expectation for the coming year, as measured by the Bureau of Labor Statistics, is above 3%.

There's still too much underlying strength in the economy to call this stagflation; it looks more like "growthflation," to borrow a phrase from economist Michael Darda. The Fed has been betting that slower growth would bring inflation down, thus vindicating its decision to stop raising interest rates last year. But we all learned in the 1970s, or should have, that inflation can coexist with slower growth.

Inflation is a monetary phenomenon, and bringing it under control means creating fewer dollars. We doubt the Fed will find much inflation comfort in Friday's data, and it shouldn't. With gold near $700 an ounce and the dollar hitting record lows against the euro, the danger is too much dollar liquidity, not too little. The Fed has been hoping to see how bad the housing slump gets before it considers further tightening, but in the meantime price pressures have been building and dollars are sloshing around the world. As we said last year, we think the Fed would have done better had it not gone on "pause."

The stock market closed basically flat on Friday, suggesting that the headline GDP weakness didn't spook anyone much. The Dow's march into record territory this week signals that investors believe that the economy will emerge from this inflationary period intact. But Wall Street's professional economists have been underestimating the inflationary threat since this cycle began. There's no sign that this has changed, which means that the further tightening that the Fed will likely have to come to grips with may come as a rude awakening to some Wall Street pros.

All of which is another reason that this is exactly the wrong moment for Congress to be toying with tax increases and protectionism. The 2010 expiration of the 2001 and 2003 tax cuts is looming ever-larger as an economic question mark. We can expect to feel the effects of that event long before New Year's Day, 2011. Tax rates affect decisions throughout the economy, and unless those cuts are made permanent, or a pro-growth tax reform is put in place to replace them, their expiration will influence economic activity before that day arrives. Economic decision-makers, like the markets, try to look forward, rather than back.