The following review of economic trends is based on information available as of June 16, 2005.

The domestic economy has remained free of any major disruptions thus far in the second quarter of 2005. Although oil prices remain a wild card, fluctuating between the high-$40s to the mid-$50s per barrel, consumers have yet to moderate their spending behavior, seemingly accepting gasoline prices that now regularly exceed $2 per gallon. Businesses, still feeling the bruises of overexpansion during the first part of this decade, may be tempering any enthusiasm for both capital improvements and hiring until they feel that oil prices have stabilized, lest they commit themselves to strategies they would soon come to regret.

The Federal Reserve Board (the “Fed”) remains convinced that the economy is solid, with inflation the biggest threat. At its May 3rd policy meeting, the Fed raised the rate on short-term interest rates by 25 basis points to 3.00%, the eighth such increase of one-quarter percentage point in as many meetings. The Fed was scheduled to have met again on June 29, at which time another similar increase may have been announced. These increases are based on the Fed’s belief that short-term rates are still “too low to be consistent with sustainable growth and stable prices in the long run,” a scenario they intend to counter with rate increases “at a measured pace conditional on the outlook for inflation and economic growth.”

The Commerce Department’s Bureau of Economic Analysis said that first-quarter Gross Domestic Product increased 3.5% annualized, down from 3.8% growth in the fourth quarter of 2004. Wage and salary income grew 6.9% annualized in the first quarter on the heels of 10.4% growth in the fourth quarter, leading to an unexpected windfall in federal income tax receipts in April. The Bureau also reported that corporate profits for the first quarter of 2005 were 13.8% higher than they were for the first quarter of 2004.

While energy and food prices increased notably at the retail level in April, this surge did not manifest itself among other goods and services. The Conference Board’s Consumer Confidence Index fell sharply in April, largely due to consumers’ fears about the effects of rising oil prices on their buying power and job prospects. But as oil prices moderated in May, the Consumer Confidence Index rebounded to nearly the level from which it had fallen the previous month.

Employment, a lagging economic indicator, may have been reacting to oil prices when only 78,000 nonfarm jobs were created in May, according to U.S. Labor Department statistics, the lowest monthly gain since August 2003. Nearly half of these gains were attributed to the strong real estate market, coming in areas such as housing sales, residential construction and related retail outlets. Unemployment dropped a tick to 5.1%, its lowest point since 2001. The labor scene has been somewhat schizophrenic, with strong monthly gains (300,000 in February and 274,000 in April) followed by anemic numbers (122,000 in March and 78,000 in May).

The housing market remains especially robust, due to low long-term interest rates. Seasonally adjusted rates of sales of both new and existing houses reached record highs in April. Fed Chairman Alan Greenspan suggested that there may be “froth” in some local real estate markets, but he does not believe that housing prices have escalated dangerously when considered on a national basis.

The U.S. dollar strengthened against the euro late in the second quarter, due largely to voters in both France and the Netherlands rejecting the European Union constitution, throwing into doubt possible economic reforms that have been on the drawing board. As of June 15, one euro could be obtained for $1.21, down from $1.36 on December 31.

Stocks rallied late in the quarter, with mid-caps outperforming both large-cap and small-cap stocks. At publication date, mid-caps were up more than 3% for 2005, with large-caps and small-caps essentially even. The Health Care and Utilities sectors enjoyed the best performance in the second quarter. Energy remains the best performer of 2005 to date, up more than 19% for the year in mid-June. The Materials sector, comprised largely of chemicals, metals and paper companies, suffered the largest decline during the second quarter, down over 5% at press time.

The yield on 10-year government bonds fell to 3.89% in early June, its lowest level in 14 months and one typically associated with a weak economy. While the Fed influences short-term rates, the bond market determines prices and yields for long-term securities. Mr. Greenspan expressed uncertainty as to why long-term rates have fallen as they have, dismissing several theories, such as a weak economy, underfunding of retirement plans, heavy buying of U.S. Treasury securities by foreigners and disinflationary effects of globalization. “The economic and financial world is changing in ways that we still do not fully comprehend,” Mr. Greenspan said in early June at a conference in China. Notable, on the corporate level, was the downgrading of debt issued by General Motors and Ford to “junk” status by Standard & Poor’s.

Unlike the summer of 2004, when various uncertainties about the economy hobbled everyone from investors to employers, the domestic economy seems to be on firmer ground now. Although inflation could escalate, especially if oil prices break out of their current price range, there do not appear to be any imminent threats to knock the economy off course.

Source: The Wall Street Journal

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