Shaking the Brick-And-Mortar Econoday Simply Economics 2/21//00 By Evelina M. Tainer, Chief Economist

It's all about Greenspan
Nothing new about the fact that the dazzling tech economy is outshining the old-line industrial base. Even when blue chip stocks were on a rising trend last year, they had a hard time keeping up with that soaring star which we call the NASDAQ composite. Since the beginning of the year, the Dow Jones Industrials and the S&P 500 have pointed south. Markets tried to recover from time to time, but this week the southern direction was strong -- particularly after Greenspan's semi-annual Humphrey-Hawkins testimony.

Greenspan's comments were generally not all that different from earlier speeches. He's worried about imbalances in the economy that are coming from excessive demand. He is concerned that consumer spending is outpacing income growth by a strong margin and that household wealth is growing about twice as fast as income -- and helping to support the strong consumer demand.

Greenspan believes that productivity could continue to grow at a healthy pace in coming months, but even that may not be enough to hold wage pressures in check. He admits that inflation appears benign, but rising energy prices may eventually cause greater disruptions.

Basically, he feels that asset prices (equity prices) need to grow at a slower pace so that the "wealth effect" which causes consumers to spend more than they earn will diminish. It almost appears as though he wishes to target the equity market now.

The NASDAQ composite index and the Russell 2000 have gained new territory this week even though they tumbled on Friday with the rest of the market. The NASDAQ composite is growing rapidly because investors believe potential returns in tech stocks are clearly greater than current market interest rates -- even with further rate hikes by the Fed. The Russell 2000 -- the primary index of small-capitalization stocks -- does have a strong element of technology which is contributing to its rise. However, the gains in this index are somewhat more broad-based helping small-cap stocks in several industries.

Treasury Market stabilizes
Treasury prices fluctuated less dramatically this week relative to the previous three weeks. It seems that bond investors are becoming more accustomed to the Treasury's plan to reduce borrowing this year. The 30-year bond remains a question mark, but it appears to have stabilized. The long end of the Treasury market is not doing its job as a market benchmark these days. The drop in Treasury yields would have led to declines in corporate bond yields and declining mortgage rates. Mortgage rates are rising (up to 8.38 percent on a 30-year fixed this past week) and so are corporate bond yields.

Markets at a Glance Weekly

Treasury Securities	12/31/99	Feb 11	Feb 18	Weekly Change
30-year Bond	6.48%	6.29%	6.16%	-13 BP
10-year Note	6.43%	6.62%	6.49%	-13 BP
5-year Note	6.34%	6.72%	6.68%	- 4 BP
2-year Note	6.24%	6.63%	6.63%	unch
Stock Prices
DJIA	11497*	10425*	10221*	- 2.0 %
S&P 500	1469*	1387*	1347*	- 2.9%
NASDAQ Composite	4069*	4395*	4416*	+ 0.5%
Russell 2000	505*	537*	546*	+ 2.2%
Exchange Rates
Euro/$	1.0008	0.9866	0.9854	- 0.1%
Yen/$	102.40	108.99	110.96	+ 1.8%
Commodity Prices
Crude Oil ($/barrel)	$25.60	$29.35	$29.50	+ 0.5%
Gold ($/ounce)	$289.60	$313.90	$307.10	- 2.2%

(BP = basis points; stock price indices are rounded)

Favorable inflation news helps dampen Greenspan effect
Two major price indicators both revealed that inflation remains subdued despite rising energy prices. The producer price index was unchanged in January, while the so-called core PPI (which excludes food and energy prices) fell 0.2 percent. Various components posted declines and helped keep down the total index, but there is no question that the usual suspect -- tobacco -- pushed the PPI far below what it would have been. Tobacco prices plunged 4.2 percent in January. After contributing to sharp gains in the total PPI last year, this drop may only seem fair. As market pundits were quick to cite its part in the PPI rise last year, it is only appropriate to remark on its contribution to a fall in the PPI here.

As the probability of inflation increases over the maturity of an economic expansion when resources are tight, market participants look to every possible leading inflation index. Among producer price indices, one would expect that the crude materials index and the intermediate goods index to give a heads up on inflation in the pipeline. We have found that these indices don't always lead the finished goods index, but they could very well signal a squeeze in profit margins. In January, the crude materials index jumped 2.7 percent -- with the nonfood, nonenergy component gaining 3.2 percent. Nonfood, nonenergy raw materials prices are now 16.9 percent higher than a year ago.

The jump in raw materials prices hadn't yet seeped into intermediate goods prices which rose 0.4 percent in January. Excluding food and energy, they were up 0.3 percent for the month, but are only 2.4 percent higher than a year ago. Incidentally, the PPI for finished goods (excluding food and energy prices) is only up 0.8 percent from a year ago. Let's call that profit-squeeze.

The consumer price index rose 0.2 percent in January, the same as the past several months. Food prices were unchanged, but energy prices increased 1 percent. Excluding food and energy prices, the CPI rose 0.2 percent in January, after a smaller 0.1 percent hike in December. The price behavior among the various components was quite similar to previous months, although apparel prices fell sharply. In contrast to the PPI, tobacco prices rose in the CPI reflecting higher taxes on cigarettes.

Notice the upward trend in the CPI in the chart above. Total consumer prices are up 2.7 percent from year ago levels. Excluding food and energy, though, the core CPI is actually recording smaller year-over-year increases and was up 1.9 percent in January 2000. Unfortunately, we can't eliminate food or energy from our budget, so the total CPI is the appropriate measure to look at over a longer time horizon than just one month.

The bottom-line on inflation? Inflation news is favorable for the most part. Producer prices are subdued and the bulk of the rise in the consumer price index stems from energy. Import prices showed that energy prices continue to rise, but at a slightly slower rate from a year ago. Global competition is keeping export prices in check. Basically, the Fed is worrying about inflation because of its potential to accelerate. Acceleration in prices at earlier stages of processing does indicate that Fed officials need to be on high alert for price pressures. As Greenspan indicated at the Humphrey-Hawkins testimony, the Fed prefers a gradual approach to policy changes because it helps keep financial markets more stable. These kind of inflation figures support gradual increases of 25 basis points in the federal funds rate target going forward, not a swift spurt in the funds rate target as some market players had feared earlier in the year.

Industrial hustle and bustle
The index of industrial production jumped 1 percent in January after recording more moderate gains in the previous few months. As a result, total production is now up 5.5 percent from a year ago. To some extent, the improved production picture points to increased export demand over the past six months. Also, it becomes more important to satisfy demand domestically when improved economies overseas have a greater need to satisfy their own demand for goods.

As industrial production has picked up, so has the capacity utilization rate. In the past, a utilization rate approaching the neighborhood of 83 to 85 percent signaled supply bottlenecks and inflationary pressures. In a global environment, that may be less important. In any case, current levels are not in the danger zone yet.

The bottom-line on production? In the previous couple of years, domestic production was on the anemic side even as the demand for services surged. This helped to keep resource limitations in check because U.S. consumers and producers satisfied demand by purchasing foreign goods. As domestic production picks up steam, it creates greater concern from Fed officials who are trying to cool down economic activity. Current production growth certainly supports the Fed's intention to tighten credit conditions further in coming months.

Housing activity: as strong as ever
Housing starts rose 1.5 percent in January to a 1.775 million unit rate. While the monthly gain in starts was less than expected, the level was much higher than expected. It turns out that housing starts were revised back several years to include not only new seasonal factors but also a revised definition for starts. In the past, multi-family structures needed independent kitchens for each unit. Now, a unit can be considered housing without its own kitchen. Where would that happen? Residences for senior citizens often follow this scenario. Given the aging population, it won't be surprising to see more types of this construction and it means that housing levels will remain strong going forward.

The bottom-line on housing? Typically, economists and policy-makers look at single family housing starts to gauge housing demand, which is sensitive to interest rates. While single family housing units declined modestly in January, the average level for the past three months is higher than three months ago. Ergo, housing remains way too healthy given the Fed's inclination to cool down this hot economy. The chart above shows that mortgage rates have risen sharply in the past few months, but higher rates are obviously necessary to dampen construction activity.

THE BOTTOM LINE
Despite friendly news on inflation, market players remain skittish over the Fed's inclination to tighten credit conditions and raise interest rates. The sanguine inflation environment actually helps the Fed to maintain a gradualist approach to tightening the screws. Most economists and market players now expect the Fed to raise rates at least three or four more times this year by increments of 25 basis points.

Activity in the economy is hopping. Industrial production surged in January and housing starts continue to surpass expectations.

Alan Greenspan testified before the House Banking Committee this week for his semi-annual Humphrey-Hawkins remarks. His views haven't changed from earlier this year, but he seemed a bit more adamant about the potential for inflation and the fact that the economy is showing no signs of slowing down. Market players would say that he sounded "hawkish".

Looking Ahead: Week of February 21 to February 25
Market News International compiles this market consensus which surveys about 20 economists every week.

Wednesday
Market players will listen to Greenspan's Humphrey-Hawkins testimony to the Senate Banking Committee. The prepared remarks will be identical to those presented to the House Banking Committee this past week, but the question and answer session could be illuminating.

Thursday
Market participants are expecting new jobless claims to rise 2,000 in the week ended February 19 from last week's 283,000 level.

The consensus shows that durable goods orders could decrease 2.0 percent in January after a 5.5 percent boost in December. This would be a modest drop after several strong months at the end of 1999. Also, it would reflect a drop in the volatile aircraft sector.

Friday
Economists are predicting that the Commerce Department will revise up its advance estimate for real GDP growth in the fourth quarter to a 6.5 percent rate. This would reflect greater demand as economists look for more final sales growth as well to a 5.3 percent rate. Consumption and construction expenditures will both be revised higher. The net export deficit will show less of a drag. At the same time, the GDP price deflator is expected to remain unchanged at 2 percent.

The market consensus shows that existing home sales should decline 1.2 percent in January to a 5.0 million unit rate. This partly reflects slower growth coming from higher mortgage rates.