Sizzling Economy, Fears of Inflation Put Stocks in Dive

The economy grew at a red-hot annual rate of 5.8% during the last three months of 1999, the government reported Friday. But inflation also showed signs of reawakening, triggering a wave of selling in the stock market in anticipation of vigorous interest-rate hikes by the Federal Reserve.

Growth for all of last year was a robust 4%, making 1999 the third straight year in which economic output grew by at least that much.

Not even in the booming 1960s had the economy grown so fast this far into a period of uninterrupted expansion. In fact, at eight years and 11 months, this expansion is poised in February to become the longest ever.

Economists have wondered for months why today’s strong growth and rock-bottom unemployment rate were generating no visible signs of inflation. So they were not surprised that the data released by the government Friday offered the clearest evidence yet that wage and price pressures are building.

“It’s as if there’s been a murder, and we still don’t have the body, but now bits of DNA evidence are starting to come in,” said Rajeev Dhawan, director of econometric forecasting at the UCLA Anderson Forecasting Project.

Inflation’s danger signals were visible in a Labor Department report that wage and benefit costs to U.S. businesses rose by 1.1% in the fourth quarter, a greater increase than private forecasters had been expecting. Higher health insurance costs were at least partly to blame.

The Commerce Department’s broadest gauge of inflation--one that assesses wage and price increases across the entire range of economic production--rose at an annual rate of 2%, nearly double the pace of the previous quarter. The last time this measure registered higher was in the beginning of 1997.

Until Friday’s news, most investors seemed to be expecting the Fed to raise short-term rates by one-quarter of a percentage point next Wednesday by boosting the federal funds rate (which banks charge each other for overnight loans) from 5.5% to 5.75%.

Interviews with investors Friday found them revising their predictions upward to a half a point increase Wednesday or two consecutive quarter-point increases, one next week and the other in March.

That was enough to trigger a selling spree in stocks, with the Dow Jones industrial average plummeting 289 points, or 2.6%, to 10,738.81, its lowest since Nov. 11. The Standard & Poor’s 500 index dropped 38.40 points, or 2.8%, while the technology-heavy Nasdaq composite index plummeted 152.49 points, or 3.8%.

Private economists, reacting more calmly than the markets, said they still believed Federal Reserve Chairman Alan Greenspan could guide the high-flying economy to a “soft landing.” But they agreed that doing so would take higher interest rates than previously thought.

Paul Kasriel, chief U.S. economist at Northern Trust Co. in Chicago, said he expected three interest rate increases from the Fed in coming months, starting with one of a quarter of a percentage point next week.

“There is now some justification for a [half-point] increase, but the Fed has not really prepared the markets for such an aggressive increase,” he said. “Greenspan has typically given the markets a heads-up when he’s going to do anything out of the ordinary.”

The Fed’s Open Market Committee last raised rates by more than one-quarter of a percentage point at a time in early 1995.

David M. Jones, chief economist at the New York bond house of Aubrey G. Lanston & Co., said he no longer ruled out four interest-rate increases by June. That is when most observers expect the Fed to recede from view to avoid any appearance of playing favorites during the presidential election campaign. He said he expected each increase to be a gentle nudge of one-quarter of a point.

“A half-point rate hike might crash the market,” he said. “The trouble for the Fed is, it has to be careful as it tries to achieve a soft landing. It wants to tighten just enough to achieve sustainable demand growth, but not too much so that it punctures the stock market bubble or causes other damage.”

The dollar strengthened against the euro and other benchmark currencies Friday, and Jones said this was evidence that international investors believed Greenspan could achieve the delicate balancing act.

A key source of the alarm among U.S. economists and investors Friday was a Labor Department report showing that the cost of wages and benefits to U.S. business rose by 1.1% during the fourth quarter.

The increase was larger than the 0.9% increase private forecasters had been expecting, and it marked a substantial increase from the third quarter’s 0.8% rise.

Health insurance costs rose as a period of intense competition ended and surviving carriers found they could once again pass on cost increases to their customers. The cost of providing medical benefits to employees was 5.8% higher in the fourth quarter of 1999 than the same period in 1998, Kasriel said.

“That’s the fastest rise since the fourth quarter of 1993,” said Kasriel, predicting that more such increases were in store. A survey of U.S. employers last month showed they expected spending on health benefits to rise by 7.5% this year. California expectations are in line with those nationally.

UCLA’s Dhawan said that for him, the “danger point” in Friday’s data was the so-called GDP deflator, a gauge economists use to separate real increases in economic output from those generated by price increases. The GDP deflator rose to an annual rate of 2% in the final three months of 1999, up from 1.1% in the previous three months.

“That’s a very big change,” said Dhawan. “Now you have evidence that inflation is popping up.”

The GDP deflator, unlike the more familiar consumer price index, includes foreign trade, government spending and many other large items. So it often yields entirely different results than narrower measures like the CPI.

Times staff writer Thomas S. Mulligan in New York contributed to this story.

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Inflation Up, Rates to Follow?

One indicator of inflationary pressure is the employment cost index, which shows that the cost of maintaining an average employee on the payroll rose by 1.1% in the last three months of 1999. To slow the economy, the Federal Reserve may raise interest rates next week.

Employment Cost Index

Percent change in the cost of maintaining a typical employee on the payroll:

Federal Funds Rate

The interest rate at which banks lend to each other overnight: