Fears calmed on potential interest rate hike

Bloomberg Business News

WASHINGTON -- The financial markets' heart attack over July 5's strong June jobs report may turn out to be just a case of heartburn after all.

Interest rates fell Friday -- just the opposite from the reaction to the strong jobs report -- following the release of government reports showing no threat of an inflationary breakout as consumers rein-in their buying and the economy begins to slow.

"The market has changed its mind," said John Burgess, chief fixed income strategist for Bankers Trust in New York. Most investors now are "very comfortable" with the view that the Federal Reserve won't raise interest rates before its next scheduled meeting, August 20.

The optimism was fed by a Labor Department report that prices at the wholesale level rose just 0.2 percent in June. While that was higher than some expectations, the report said producer prices for energy, semi-finished goods and raw materials all declined -- leaving few, if any, pressures to push consumer prices up. The official report on June consumer prices will be released Tuesday.

Fed policymakers prefer to raise rates, always an unpopular move, on bad inflation news rather than good employment news. The June wholesale price report "is not a bad inflation number, about what one might expect in today's world," said Alan Blinder, the former Fed vice chairman who returned to teaching at Princeton University.

Patrick Flaherty of Fleet Financial in Hartford is even more emphatic: "We have survived strong growth, survived an oil price shock, yet seen a deceleration of prices" at the wholesale level, he said. "Inflation is just not a problem."

The fact that hourly wages are rising faster than the cost of living, normally a sign of more inflation to come, is no cause for alarm, according to Joseph Stiglitz, chairman of President Bill Clinton's Council of Economic Advisors. Not only are employers getting more output from their workers, he said, but the cost of fringe benefits is easing.

"Its important from the inflation side that one focuses on the overall costs to firms -- compensation, not wages," Stiglitz said. So far this year "compensation has been growing at a very moderate rate." The employment cost index for the second quarter will be released on July 30.

Moreover, evidence is surfacing that the economy, which most analysts believe expanded at a brisk pace (a 4 percent annual rate or better) in the April-June quarter, is headed for a slowdown that will prevent a potential inflationary overheating. The government's preliminary report on second quarter gross domestic product will be released August 1.

Though the Fed hasn't raised the rates it controls, investors in the bond markets pushed up long term interest rates by almost 125 basis points and intermediate term rates by more than 150 basis points in the period from mid-February through mid-May.

Given the lag time involved, the full effect of that move is yet to be felt. However, the first faint signs of a possible economic slowdown are appearing.

Retail sales fell unexpectedly in June to their lowest level in almost a year, the Commerce Department reported Friday. Significantly, sales in the interest-sensitive auto industry declined, only the second monthly drop since last September.

Thursday, the Labor Department reported the number of people applying for first-time unemployment benefits increased for the first time in a month last week. While not a particularly reliable indicator, the rise in weekly jobless claims could be an early sign that the surge in hiring is ebbing.

Disappointing as that would be to job-seekers, a hiring slowdown would be welcome news to the inflation-fighters at the Fed. It was last Friday's report that unemployment fell to 5.3 percent in June that set off inflation alarms, provoking speculation that Alan Greenspan and his colleagues will be raising interest rates before long. The jobs report was released after the Fed's policy meeting last week, at which rates were left unchanged.

Other inflation signs are popping up. Wholesale food prices did increase in June, particularly for beef and fresh fruits. Over the past two weeks prices for some key industrial commodities have gone up.

Despite the retail sales slump last month, consumer confidence remains high. Factory orders rose in June as retailers replenished their depleted inventories in anticipation that consumers will manifest their good feelings by going shopping.

Some analysts believe that when the government releases its preliminary report on second quarter gross domestic product on Aug. 1, it will show an economy suffering from severe overheating with GDP expanding by close to 5 percent -- double what the Fed regards as noninflationary growth.

"The best news on inflation is behind us," said Sung Won Sohn, chief economist at Norwest Bank in Minn. "We are going to get some unpleasant surprises down the road, and I think (the Fed) will have to take out an insurance policy."

Should the Fed decide to take out that policy by raising rates, it will have to be sensitive to the political calendar in this election year. The Fed's Aug. 20 meeting falls between the Republican and Democratic conventions. The board probably would prefer to avoid action that provides ammunition for its critics.

The problem for Greenspan and the others is compounded by the fact that if they lie low at the August meeting, the next scheduled meeting is September 24, even closer to the November election.

It's for those reasons that many economists believe that the most opportune time for the Fed to raise rates -- if it wants to -- will be in the period after Greenspan delivers his semiannual review of the economy to Congress on July 18 and before the Republicans open their convention in San Diego on Aug. 12.

Those looking for economic portents will have a busy week ahead. Today the Commerce Department will report on business inventories, and on Tuesday reports industrial production and capacity utilization. The Labor Department reports the Consumer Price Index on Tuesday as well.

Wednesday the Commerce Department reports on housing starts, and Thursday releases the merchandise trade report. Thursday the Labor Department reports initial jobless claims and the Philadelphia Fed releases its study of regional economic conditions.

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