Tue Jul 20, 2004
By Victoria Thieberger

NEW YORK (Reuters) - The U.S. economy will show solid growth this year as hiring picks up, but economists see slower growth and higher inflation than they did earlier in the year, a Reuters poll shows.

That makes for an awkward combination for the Federal Reserve, which is nevertheless expected to continue raising borrowing costs at a slow and steady pace through this year and 2005, according to a poll of 30 economists.

The broadest measure of economic output, gross domestic product, is forecast to rise 4.0 percent this year on an annual basis, down from 4.3 percent in the previous survey taken in April.

For 2005, growth forecasts edged up to 3.7 percent from 3.6 percent.

The recent weak patch of economic news for June, on consumer spending, employment and industrial production, has not dented most economists' view of an economy reaching cruising speed.

They see a solid expansion even though two big props of stimulus -- tax cuts and super-low interest rates -- have faded. Businesses have begun to take up the spending baton from tired and overextended consumers, whose outlays have supported the economy over the past three years, but who have accumulated high levels of debt.

"We are viewing the current slowdown as a temporary soft patch and the economy will come back. Income is going up faster than consumer spending, but the real heavy lifting is going to be done by business spending," said Sung Won Sohn, chief economist at Wells Fargo.

Until a few months ago, corporate America was keeping a tight rein on hiring and slowly ramping up investment. But that caution seems to have finally dissipated.

PRICING POWER IS BACK

The fly in the ointment of most forecasts, though, is the price of oil, which was the main cause of upside shocks on inflation in recent months.

Economists have ramped up their estimates for the consumer price index to 2.6 percent in 2004 and 2.4 percent next year, far above their estimates of 2.0 percent and 1.8 percent made just three months ago.

"All the signs are that firms are both willing and able to raise prices," said Deutsche Bank's chief economist, Peter Hooper.
Still, underlying inflation, which strips out food and energy costs, is expected to remain close to the zone of price stability between one percent and two percent this year, which should allow the Federal Reserve to maintain a "measured" pace of tightening.

The risk is that if oil shoots higher, those inflation forecasts will be thrown out of the window and the Federal Reserve will be faced with the twin problems of a contractional shock from higher oil prices and an inflation threat.

"The earlier increases in energy prices are cascading through the economy, and the price of everything from plastic toys to medicine is affected," said Sohn.

AT LONG LAST, JOBS

Employment, which was the missing link in the recovery until a few months ago, has improved as companies gained confidence in the recovery's staying power.

"Certainly all the surveys tell us firms are in hiring mode now," said Deutsche's Hooper.

This is essential to maintain momentum in the recovery, since incomes must keep rising to support consumer spending. So far, non-wage income has been strong, but wage growth has lagged and will need to rise to sustain consumer spending, which accounts for two-thirds of U.S. economic activity.

Analysts in the Reuters survey see only slight improvements in the unemployment rate, from June's 5.6 percent to 5.4 percent at the end of this year and 5.2 percent by mid-2005.

One of the factors slowing the improvement in the jobless rate is the likely return of discouraged workers who gave up searching for jobs during the downturn and hence were no longer counted by the official unemployment statistics.

As those people rejoin the work force, they will again be counted. The hope is that the economy can generate enough new jobs over coming years to get the unemployment rate back to the halcyon levels near four percent last seen during the high-tech boom.

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