Oct. 27 (Bloomberg) -- The U.S. economy is coming off its fastest pace of growth in almost four years, and even U.S. Treasury Secretary John Snow told the London-based Times last week he expects interest rates to rise as the economy expands. Don't count on the Federal Reserve to make the first move. The Fed's Open Market Committee will leave its benchmark federal funds rate at a 45-year low of 1 percent tomorrow, according to all 92 forecasters surveyed by Bloomberg News. Economists from half of Wall Street's 22 largest bond firms, including Merrill Lynch & Co. and Goldman Sachs Group Inc., don't expect any rate increases by the U.S. central bank until 2005.
``There's no doubt'' the Fed will keep rates low for a long time to come, Joseph Stiglitz, former chairman of the president's Council of Economic Advisers and winner of the 2001 Nobel Prize in economics, said in an interview. ``Many of the fundamental problems underlying our economy are still there.'' The U.S. economy has lost 2.7 million jobs since March 2001. An increase of 57,000 jobs in September, the first gain since January, isn't enough to absorb the 100,000 people entering the labor force each month, and higher productivity may continue to mute hiring and sap consumer confidence, Richmond Fed President J. Alfred Broaddus Jr. said earlier this month. Both investors and economists tend to agree short-term rates will rise sometime over the next 18 months. They diverge on when and even why. Unlike the European Central Bank, which meets Nov. 6, the Fed doesn't disclose numerical targets for inflation, making it difficult for forecasters to judge how price increases will influence Fed decisions.
Productivity Gains
Another complication is that rising productivity, or output per hour, allows U.S. companies to meet demand with fewer workers, making it difficult for the Fed to judge what level of growth will produce firmer prices and more jobs. Steelcase Inc., the largest maker of office furniture, just built a factory in City of Industry, California that can now produce in 2.5 hours what used to take 3.5 days in older plants. Employees no longer make ``batches'' of parts; instead, they produce as sales dictate and handle the assembly less. Worker productivity is up about 25 percent.
``As we drive for greater efficiency, it allows us to produce more with the same number of people,'' Mark Baker, senior vice president of operations for the Grand Rapids, Michigan-based company, said in an interview. Even as production increases, ``we don't need to bring more people on.'' Productivity gains are also reducing the firm's need to invest. Capital expenditures at Steelcase fell to $76.5 million in the fiscal year ended in February from $260.5 million two years ago, in part because employees are learning how to squeeze more out of existing processes and equipment, Baker said.
Fed's Targets
``The fact that productivity is growing strongly means the amount of spare capacity that we have at the moment is probably going to be with us for quite some time,'' Jan Hatzius, senior economist at Goldman, Sachs & Co., said in a television interview with Bloomberg News last week. Factory-use rates stood at 74.7 percent in September. In the 1990s, utilization averaged 82 percent. Both the ECB and the Bank of England specify numerical inflation goals. Some Fed members including Broaddus and Governor Ben S. Bernanke have complained that not disclosing targets creates confusion in financial markets.
For the Bank of England, for example, economic growth and inflation above the BOE's 2.5 percent target have led investors and economists to predict a rate increase by the end of the year, if not at the bank's meeting on Nov. 5 and 6. Euro region economies are struggling to grow and economists forecast inflation will fall below the European Central Bank's 2 percent target next year. So the ECB isn't expected to change rates until the middle of 2004.
March Boost?
Eurodollar futures traders think the benchmark overnight rate could rise as early as March. Economists disagree, because even with strong growth there is little evidence that product prices or wages are moving higher. Inflation, as measured by the Fed's preferred core personal consumption expenditures index, has held at a 1.3 percent annual rate of change in four of the past five months. Output per hour rose at an average annual rate of 4.8 percent over the past eight quarters, compared with a 1996-2000 average of 2.5 percent. The effect of this ``productivity shock,'' as Fed officials call it, is hard to predict. ``Productivity increases are not raising demand as much as might have been expected and may even have been delaying the recovery of investment by enabling businesses to increase output without expanding physical capacity,'' said Federal Reserve Governor Donald Kohn in a speech last month.
Double Edge
Steelcase, for example, is experiencing the downside of productivity gains. The market for office furniture has contracted because companies aren't hiring. Steelcase's revenue fell 16 percent in fiscal 2003 to $2.58 billion from $3.08 billion the previous year. FPI Thermoplastics Technologies, in Morristown, New Jersey, a family-owned maker of plastic products ranging from McDonald's Corp. lunch trays to housings for Siemens AG smoke alarms, is also doing more with less. A $50,000 investment in automated assembly now allows the company to put together smoke detectors with four people instead of 10. ``This device only took 3 months to pay for itself,'' said Sam Murray, executive vice president. ``And while it has replaced 6 workers, we have been able to save four manufacturing jobs in America.''
`No Reason to Tighten'
As production costs tumble, ``the big question is when does inflation start picking up?'' said Ian Morris, vice president and chief economist at HSBC Securities USA Inc. He said that investors betting on an inflation rate of 2 percent or 3 percent in a year are probably wrong. Morris predicts the Fed will keep interest rates at 1 percent for all of 2004, a view shared by economists at Lehman Brothers Holdings Inc. and Nomura Securities International Inc. ``I see gross domestic product growth just under 4 percent next year,'' said David Resler, Nomura's chief economist. ``At that growth, the economy will be expanding at less than potential and inflation will remain subdued. The Fed will have no reason to tighten.'' At best, Fed committee members may do no more than acknowledge accelerating growth and perhaps tweak language in their statement at tomorrow's meeting. The economy probably expanded at a 6 percent annualized rate last quarter, the fastest since the final quarter of 1999, according to the median forecast in a Bloomberg News survey. The Commerce Department will report third-quarter GDP on Thursday.
``After a couple of years of growth below potential, we could have a couple of years above potential without igniting inflation,'' said Dale Jorgenson, a Harvard University economist who has focused on productivity in many of his more than 200 papers. ``The Fed should just lie low for the time being.'' //www.bloomberg.com