Just Where Is This Wild Ride Heading?

The U.S. economy is in transition. The question is, transition to what?

Despite Tuesday’s spectacular stock and bond market rallies, which were sparked by government reports suggesting that a slowdown in the economy could be imminent, there is a large camp on Wall Street that expects just the opposite: continued strong growth, along with a new bugaboo of rising inflationary pressures.

Another vocal camp is not only confident about an economic slowdown, but also worries that business and consumer activity could soon ebb too much--which could be bad for the stock market, although probably good for the bond market.

In relatively short supply, meanwhile, are Wall Streeters who think “Goldilocks” is still alive: the “not-too-hot, not-too-cold” economy that grows at a moderate pace without significant inflation, keeping interest rates in a relatively narrow range and giving stocks’ bull market a new lease.

The Goldilocks crew could, of course, have it right. That has been the economy’s story since early 1995, and a lot of money has been lost in markets betting against it.

But in the seventh year of the economy’s expansion, with the labor market extremely tight, consumers generally feeling good, and many factories straining to keep up with demand, the argument that growth will continue at a robust pace--and ultimately fuel higher inflation--has many adherents.

“My judgment is that we’re going to get continued strong economic statistics,” said John Williams, economist at Bankers Trust in New York.

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Despite Tuesday’s reports that factory orders for big-ticket goods fell in March, and that consumer confidence dipped, Williams sees those as momentary lulls. U.S. consumer spending, he notes, accounts for two-thirds of economic activity, and there is little to suggest that consumers will dampen spending much in 1997, he said.

As for the principal catalyst of Tuesday’s stock and bond rallies--the smaller-than-expected rise in the first-quarter employment cost index, or ECI--many economists say they simply don’t understand how that figure could be so low.

John Lonski, economist at Moody’s Investors Service in New York, says there is a growing discrepancy between the government’s measure of wage and salary growth in its monthly personal-income report, and the rise in employment costs in the quarterly ECI. By the former measure, Lonski estimates that wages and salaries were up twice as much in the first quarter versus the ECI reading.

What’s more, the ECI showed benefit costs up 0.1% in the first quarter, a minuscule rise that makes no sense, some experts contend. They point out that medical coverage costs, such as for health maintenance organization membership, are rising for the first time in five years. That should be showing up in the ECI.

Yet it’s the anecdotal evidence that moves many Wall Streeters to conclude that employment costs are going up sharply, even if government data isn’t concurring.

Robert Rodriguez, manager of the FPA Capital and FPA New Income mutual funds in Los Angeles, recalled a conversation he had recently with the head of a uniform-supply firm. Rodriguez asked the executive if he agreed with people who say wages aren’t accelerating significantly.

“B------t!” the executive exclaimed. Employee turnover, the executive told Rodriguez, is rising so rapidly that he is being forced to pay much more to retain workers.

And while that’s obviously great for the workers, for Fed Chairman Alan Greenspan it will be nightmarish if it leads more companies to try to raise prices, generating higher inflation overall--Public Enemy No. 1 to the Fed.

Because Williams, Rodriguez and others in their camp believe the economy is just at the start of a higher-inflation cycle, they don’t believe the Fed is done tightening credit. Thus, they don’t believe that bond yields will stay down for long. And if that’s true, stocks’ tough times aren’t over, either.

“I’m still of the assumption that long-term bond yields end the year higher than they are today,” Rodriguez said.

Williams also points out that the surging dollar is helping the European and Japanese economies this year by boosting their competitiveness with the United States. Stronger growth worldwide could put additional upward pressure on inflation and interest rates.

Meanwhile, on the figurative other side of Wall Street is a vociferous camp that says the economy’s problem isn’t that it needs to be slowed, but that it is rapidly fading.

Scott Grannis, economist at Western Asset Management in Pasadena, believes that interest rates have already risen enough to cool the economy. The risk now, he says, is that the Fed decides to continue tightening credit and drives the economy into a wall.

Grannis maintains that there is no reason to believe that the tight labor market, higher wages and busy factories will mean higher price inflation. Economic models that predict such are “antiquated,” he says, and don’t account for the globalization of the economy (meaning greater competition that keeps prices down) and the ongoing gains in worker productivity.

While other economists believe consumers are capable of continuing their spending binge, Grannis argues that high tax burdens will act as a drag on spending.

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Finally, Grannis believes that the dramatic declines in many small-company stocks this year, versus the minor declines in blue chips, provide a clear indication that the domestic economy is on the verge of slowing sharply.

Because smaller companies tend to be more dependent on the domestic economy (rather than on overseas sales), the pummeled stocks must be signaling a fundamental problem with business ahead, Grannis says.

William Nasgovitz, money manager at Heartland Advisers in Milwaukee, also views the small-stock plunge as a warning that “the economy is slowing down.” The slumping price of gold and other industrial raw materials is saying much the same, he says.

Massive Rally:

* Favorable inflation news sends stock prices soaring. A1

* Wages, benefits rise a modest 0.6% in first quarter. D3

* As the Dow flirts with record levels, bonds also surge. D6

* Equity fund buyers are hedging their bets. D6

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Have Rates Peaked?

Bond yields fell sharply Tuesday in the wake of economic data suggesting a slowdown could be in the offing. But many experts aren’t convinced that consumer and business activity will ebb enough in the near term to justify significantly lower rates. Thirty-year Treasury bond yield, weekly closes since April 1996 and latest:

Tuesday: 6.98%

Source: TradeLine