ECONOMIC ANALYSIS: Revisiting the crystal ball reflects timid predictions

When economists look into the future, what do they see?

Many of us reported our visions of the coming year late last fall in annual forecasting presentations. Our Ball State University forecast, like many others, was pretty optimistic about 2005. It foresaw reasonably strong growth for both the U.S. economy and Indiana.

But as we start the second quarter, with four more months’ worth of fresh data in hand, is there any reason to change that outlook?

It depends on whom you ask. All of us make forecasts, after all, as revealed in the decisions we make on how we spend and invest our money. And when it comes to the consumer, the consensus forecast clearly remains upbeat, judging from the two-fisted spending of late.

Among professional forecasters, there is no simple consensus. But it is clear that the U.S. economy is running a little hotter right now than many had expected. And the potential for some corrective action by the Federal Reserve is making interest-ratesensitive sectors of the economy edgy.

We’ll soon get our first news on overall growth in the first quarter of 2005, but judging from the strong performance of manufacturing and retail trade, it is likely to show an acceleration in the economy since the close of last year. Despite high energy prices, consumers are spending, profits remain high, and businesses are expanding.

There is good reason to believe this faster growth will continue through the summer, judging from forward-looking indicators like new durable goods orders and housing starts. The inevitably winddown in the economy will come, however, as expansion plans mature and new capital spending trails off. But the strong first half of 2005 is making our forecast of last November look a little timid-so far.

The faster growth in the U.S. economy, coming at a time when there is at least respectable growth in the rest of the world, is a mixed blessing. We’ve all seen the results of strong worldwide demand for energy every time we drive by a gas pump. What is less obvious to consumers-but frighteningly clear to some businesses-is that higher energy costs may simply be the tip of the inflation iceberg.

In this era of global competition, the simple pass-through of higher costs to customers doesn’t work quite as automatically as it once did. But even in the face of competition from abroad, the relentless pressure of higher commodity prices is being felt in the prices of final products. Toward the end of last year, prices of crude materials were running more than 25 percent higher than a year ago, though they’ve fallen back slightly in the last two months.

Prices at the retail level haven’t been nearly that ill-behaved, yet their trend growth continues to push upward. If our forecasts of the economy were a bit too pessimistic, the opposite is true about our inflation forecast. With energy prices returning and surpassing their pre-Christmas highs, we expect higher inflation in the first half of 2005, pushing the growth in the Consumer Price Index closer to 4 percent than we have seen in years.

That pushes the policymakers at the Federal Reserve, who keep a radar gun aimed at price growth, to the center stage. The baby steps upward in short-term rates implemented so far are suddenly looking inadequate to push this muscular inflation genie back into its bottle. Look for the Fed to begin making more substantial and, to some, more painful hikes in the interest rates under its control, possibly as soon as next month.

If history is any guide, those tightening actions by the central bank won’t be fully reflected in the economy until near the end of the year. That makes it a pretty safe bet 2005 will be a year of higher growth and higher prices.