The U.S. economy has continued to slow in the year since the Federal Reserve halted a series of 17 hikes in the Fed funds rate, which stood at 5.25% in late June. Economists differ on whether the Fed succeeded in damping inflation without driving the nation into recession.

Dana Johnson, chief economist at Comerica Bank in Ann Arbor, Mich., says the Fed executed a near-perfect soft landing. “There's definitely been a slowdown, but there had to be. That's what the Fed was trying to do,” he says. “Moderate growth in the last four quarters has laid the foundation for what is likely to be an extended period of growth.”

The Gross Domestic Product (GDP) rose 0.6% in the first quarter, the lowest quarterly increase in four years. But Diane Swonk, chief economist at Mesirow Financial, predicts that better days are ahead. The manufacturing sector will provide a boost in the second quarter as depleted inventories such as cars are replaced, the result of a resilient consumer, Swonk says.

Some economists believe the economy hasn't stopped slowing, and is already in a recession or will be by the end of summer. Technically a recession is defined as two consecutive quarters of decline in GDP.

Consumer spending, which makes up 71% of GDP, is the chief reason the nation hasn't already slipped into negative growth. That saving grace is fading, however, and is expected to show about 2% annualized growth in the second quarter, down from about 4.3% in the first quarter.

A low unemployment rate of 4.5% has buoyed the consumer, experts say, but spending is sagging under the weight of gasoline prices of $3 per gallon and food prices that were up 6.7% in the first four months of 2007 compared with the same period a year ago.

The government reports that core inflation, which excludes volatile food and energy costs, dropped from an annualized rate of 2.3% in April to 2.2% in May. That's closer to the Fed's comfort level of 2%.

Jim Rogers, economist and author, disagrees that inflation is being held in check. “There is inflation in the land, and if you're in the real estate business, you know it,” says Rogers, who questions the current methods the federal government uses to track inflation.

Rogers says commodity prices have increased 250% since August 1998, but the federal government excludes raw materials from the Core Price Index in order to make inflation appear lower and keep consumers happy.

Perhaps concern over non-core inflation explains why the Fed hasn't intervened with an interest rate cut to stimulate slowing GDP growth. Some forecasters even believe the Fed will increase rates soon in order to head off inflation.

That would be bad news for the economy, says Dr. Rajeev Dhawan, an economist at Georgia State University. Dhawan believes the Fed could dodge a recession by lowering interest rates now. “If they come into the game late, then you are talking the ‘R’ word, and they will have to do more rate cuts just to shore up the economy.”
— Matt Hudgins

The 10-year Treasury yield reached a five-year high of 5.26% on June, 12, rising 75 basis points in just three months. While that benchmark for long-term, fixed-rate financing has eased since, economists say borrowers better get used to higher interest rates.

“Anybody who relies a lot on leverage would be hurt most in an environment of rising interest rates,” explains Robert Bach, research director at Grubb & Ellis. “Institutions would probably welcome higher interest rates to eliminate some competition.”

The future direction of interest rates depends on several factors. Core inflation has fallen to near 2%, but non-core items like food and fuel are climbing well above that rate. Bond buyers want higher yields to reflect their growing risk of loss due to inflation.

If core inflation follows suit, the Fed is likely to raise short-term interest rates to slow the economy. “We would not be surprised if they raise rates before they lower them again,” says Josh Scoville, director of strategic research at Boston-based Property & Portfolio Research.

For nearly three years, the 10-year Treasury yield resisted the historical tendency to run higher than short-term rates, and in fact fell below short-term rates for the past year to form an inverted yield curve. The 10-year bond's odd behavior reflected massive purchases of U.S. Treasury bonds by foreign central banks as they sought to bolster the economy.

With the shrinking trade deficit, banks are less inclined to intervene. Improving international interest rates are providing venues for capital that had poured into U.S. securities. The shift has enabled the 10-year yield to climb above the three-month Treasury yield, which registered 4.7% on June 21.

Most economists expect the 10-year Treasury yield to stay above 5% and trend upward into 2008, but not everyone. James Smith, professor at the Institute for the Economy and the Future at Western Carolina University, expects a recession this summer and a 10-year yield of 4.14% by year's end. “People buy into Treasuries for safety,” concludes Smith, “and it drives prices up and yields down.”
— Matt Hudgins