Sobering bond market, inflation fears keep rates up, analysts say

The Outlook

April 14, 1996|By Timothy J. Mullaney

Wall Street is at it again. A strong employment report sent markets reeling last week. The excuse du jour was the same: the best news on interest rates is behind us. Investors were little salved by news Wednesday that 1995's productivity gains were the biggest in three years, or by inflation reports showing prices close to dormant except for a blip in energy costs. These reports should help: more productivity means the economy can grow more without inflation, and rates theoretically rise to fight inflation. So what gives?

Cynthia Latta

Economist, DRI/McGraw-Hill.

The market is just very afraid the economy is on the verge of overheating and that inflation will take off. If it does, investors want to be protected in the form of rates that are high enough to compensate and give them a real return besides inflation.

What lay people forget -- they buy into politicians' arguments that we need to be growing faster -- is that there are two sources of growth. One is more people -- it gives you growth but not necessarily better living standards. The other is productivity improvement -- which the manufacturing sector is very good at producing and the service sector not so good. It's not clear what the Federal Reserve can do to encourage productivity growth. It's up to the innovators and entrepreneurs to come up with products that help us do more with less.

[Productivity growth in 1995] really was so-so. It was basically 1 percent, which is not as good as we've had in the past. From the 1960s and 1970s we have productivity gains about 2.25 percent a year. In the 1980s, just about 1 percent a year. From '91 to '95, that's been about 1.25. People seem to think the economy should grow at 3 percent a year. So unless you can do something about productivity, you've got to open the immigration gates, which people don't want to do, or not let me retire at 65.

Ken Goldstein

Economist, the Conference Board.

This is chickens coming home to roost. This was a market absolutely convinced the Federal Reserve was going to lower rates; it bought bonds in anticipation of the next decrease. If you've already bought and paid for the next rate cut, you've got to scramble. That's a better explanation for the market than fear of inflation.

The U.S. economy is $7 trillion big. You don't turn around something that big, that fast, that much. You can't turn the economy from stagnating into a recession to worrying about inflation the next week. A lot of [last week's decline] is just about the sobering up of the bond market, and I think it was a long time coming.

This is indeed an economy with some momentum. There will be a realization that inflation is not staying at 3 percent, and that's OK -- we end up with more growth, more jobs, more income, more profits, but inflation above 3 percent. The next stop isn't 10 percent. The next stop might be 3.5 percent.

William L. Paternotte

Chairman of Investment Committee, Alex. Brown.

I think the capital markets are on a knife's edge between an accelerating growth scenario and a recessionary no-growth scenario. We've seen vacillation between those views over the last few months. You never get all the economic news at once. You get bits and pieces, and each piece that comes out can tilt the scales. You kind of get this vacillation back and forth, which only happens when you are in an environment characterized by very slow growth.

You've also had a situation, going on at the same time, when the equity market has diverged in terms of performance from the bond market. The equity market has generally been strong this year, while the bond market has been extraordinarily weak. Typically, that divergence doesn't continue for very long, so when the stock market had 4 or 5 days of declines, which we haven't seen in a while, it really was bringing it back in line.

The question is, where do we go from here? My guess is that the bond market is oversold, and we'll see some settling out or moving up in bonds. The reason for that is I don't see any evidence of major acceleration of inflation. The major component is labor costs, and there are no signs of wages picking up.

Paul W. Boltz

Chief Economist, T. Rowe Price Associates Inc.

The stock market is making a fundamental reappraisal of the Federal Reserve's stance. We've evolved from a very favorable outlook for additional eases to a neutral stance, and now creeping into the market is the fear that the Fed will tighten before the year is out.

The market is abandoning the notion that we are near a recession. The economy has good prospects as we move into the spring. A good economy is good for corporate profits, but it also means higher interest rates, like we have now.

I think the Fed will do what it did in 1994 and head off inflation pressures before they build up a head of steam. By any reasonable historical standard, interest rates are quite low.

Pub Date: 4/14/96

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