Time To Pop The Party?

The U.S. economy roared into the 21st century like a bullet train last quarter, and the vibrations it created were rattling the china on Wall Street last week. Stock prices plunged on fears of higher inflation and rising interest rates, but neither of these variables seems likely to derail the economy this year or possibly even next.

The Commerce Department report released on Friday amounts to an impressive display of resilience. Business activity grew at a breakneck rate of 5.8% in the final three months of the year, faster than most experts had predicted. The surge in output lifted 1999's total gross domestic product 4%. That's the third year in a row the economy grew at that rate or better, a feat last accomplished in the late 1970s. When this expansion passes the February milepost, it will become the longest in American history--107 months.

INFLATION: Annual % change in CPI

The force sustaining the economy's extraordinary performance is you. Consumer spending accounts for two-thirds of all business activity, and with record low unemployment, better pay and the effervescent stock market, Americans spent 5.3% more in 1999 than they did the year before, the largest gain in 15 years. Business spending jumped 8.3% as companies not only sought to protect themselves from phantom Y2K problems but also stocked up on goods to keep holiday customers happy. The Y2K fizzle will permit companies to redirect their investments to capital spending, which serves to increase corporate productivity and boost profits.

UNEMPLOYMENT: Yearly Change

With such good news, why did Wall Street freak? In a word: inflation. A report by the University of Michigan showed that consumer confidence soared in January to an all-time high, suggesting that the consumer spending binge is far from over. Other fresh signs emerged showing that the scarcity of workers is driving up labor costs, as Federal Reserve chairman Alan Greenspan has long warned it would. The Labor Department said the employment cost index, which measures how much worker pay and benefits are rising, surged 1.1% in the fourth quarter--the biggest increase in nearly six years--and rose 3.4% for the year as a whole, much higher than expected.

That's pretty manageable in the big picture but is nevertheless a warning light flashing that inflation may accelerate as the economic expansion picks up speed. Investors feel certain that when the Federal Reserve meets this week, it will raise interest rates at least a quarter of a percentage point--25 basis points in the Street's calibration (1 percentage point equals 100 basis points)--and they fear more increases are on the horizon. Money flows out of stocks when rates rise or seem likely to, and did it ever last week. The Dow Jones industrial average dropped 513 points, to 10,738.87, its lowest level since Nov. 11. The tech-driven NASDAQ shed 8% to 3,887.07.

DOW JONES: Last Week

Many "new era" investors, who believe the use of computers has solidly lifted the nation's productivity, think the inflation threat is still way overblown. That may be true. But as long as the Fed believes the threat is real, the financial markets will react accordingly.