Economy shows strength; forecasters see risks

Martin Wolk • Profile • E-mail

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.

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