Kiplinger Connection
The Economy • Business Cost • The Dollar

The Economy: Short downturn, but long recovery.
Business Cost: Expect steel prices to skyrocket.
The Dollar: A downward spiral but no freefall.

The Economy
This economic downturn may be short... just a quarter or two of negative growth.
But recovery will take much longer, with ill effects lingering till at least 2010. There'll be no quick snapback in job growth ... no strong surge in income, spending or profits.
Why? The inflation wolf is at the door.
And the Fed will have to beat it back. We expect the Consumer Price Index to climb by about 3% this year, measured Dec. to Dec. Gasoline prices won't go up as much as in 2007, but they’ll stay high and seep into the prices of other goods. Food costs ... up about 4%.

As long as the economy is stumbling ...
Short-term interest rates will go down. The Federal Reserve wants to break the spiral of more credit tightening and reduced spending.
Once the economy regains its footing ...
The policymakers will reverse course, and fast, probably hiking rates a full point or more over a 12-month span starting in 2009.

That'll keep a lid on GDP, holding growth to no more than 2.5% in 2009, following what looks to be a paltry 1.5% gain this year.
Employment will pick up only slowly, a very gradual increase in the number of jobs, similar to what came after the 2000-2001 recession, rather than the robust bouncebacks that followed most earlier slowdowns. Unemployment isn't likely to go much below 5% again until 2010 or so.

At the same time, inflation won't be easy for the Fed to defeat.
Upward pressure on prices arises from a variety of sources:
Strong global demand for oil, steel, copper and other commodities. Even as U.S. growth shrivels, gains in China and India continue to surge.
Strains on wheat, corn, and soybean supplies as world demand mounts for biofuels and animal feeds and as yields fall because of crop damage.
Even the weak dollar, which has raised the price of imports nearly 14% over the past 12 months and will continue to nudge prices up.

None of that is likely to change much in the next year or two.
So the Fed is banking on a soft economy to rein in inflation, reckoning that unemployment will block wage hikes while weak spending by consumers won't let most companies pass on their own rising costs.
For businesses, that spells a prolonged squeeze on profits.
And for the Fed ... a long and precarious balancing act.

Expect another half-point cut from the Fed by March 18, following disappointing data on job growth and factory orders. Federal Reserve policymakers may even act ahead of the scheduled meeting and might go for a three-quarter-point cut if market conditions worsen. The Fed is also taking other steps to make more credit available.
We now expect job growth this year to be only 600,000, about half of what it was last year. Unemployment will hit 5.5% by Jan.
Adding to the slowdown...a weakness in commercial construction. Managers are being cautious, keeping a lid on inventories and hiring.

Turmoil in municipal bond markets is adding to borrowing costs. The immediate cause is concern about the reliability of bond insurers, some of which have been caught up in the subprime mortgage crisis.
Interest rates on municipal bonds now average just under 5%, after a spike to 5.4% in late Feb. A year ago, they averaged about 4.1%. A few areas are struggling with much bigger hikes. The Port Authority of New York and New Jersey saw rates of some debt soar from 4% to 20%.
Some highly rated states will try to sell bonds without insurance to keep costs down. They’re betting that rising yields and good ratings will be enough to convince investors that the bonds are worth any risk.
Larger debt payments come at a bad time. State and city budgets are getting hit hard as the weak economy sharply reduces tax receipts.

Business Cost
Some companies face double-digit postage increases this year.
Others, however, will see smaller rises or even declines. The overall May 12 rate hike can’t exceed 2.9%, but the Postal Service will use selective increases as incentives to promote automation.
Hard hit: Firms that don’t code packages for machine processing or mail envelopes, catalogs, or magazines that are irregular or bulky.
But proactive businesses can take steps to trim their costs. To reduce a 15% hike to 5%, use standard-size envelopes with bar codes. Presorting invoices can turn a 9.4% rate jump into a 4.4% price cut. Small businesses should consider bundling mail with nearby companies.

A huge wave of price bump-ups for steel products is on the way. Machinery, auto, construction, and tool manufacturing firms, among others, will pay 25% more in April than they did for the same goods in January. Hot-rolled steel will climb to $730 a ton as cold-rolled hits $830, on average. By June, prices will increase to $800 and $900, respectively. They’ll ease this summer but overall will still average 20% above 2007.
For users of stainless steel, though, relief is finally at hand. Plunging prices for nickel, a key ingredient, will bring a 15% drop in stainless. It’ll average $3900 a ton, down from $4585 in 2007.

Also bucking the inflation trend: Cell phone service. With near saturation of the market, mobile phone carriers are battling with each other to steal customers. That means offering more for less.
Expect more package deals of unlimited voice and Internet, with text and photo messaging and no roaming or long-distance fees ... all for $100 a month, a good deal for businesses, which use more minutes.

The news isn’t so good for beer drinkers. Malting barley prices are setting records at twice the usual level because of grain shortages. And hops, the other main ingredient, is running up to 25 times the norm.
Higher prices haven’t hit supermarkets yet, but they soon will. Big brewers won’t be hurt too much because they buy well in advance,
but small producers that rely on spot markets are starting to up prices.

The Dollar
The dollar's dramatic slide is scary.
It's part of a nasty downward spiral. The weak dollar is sending investors scurrying to commodity markets ... oil, gold, grains, and more ... in hopes of earning higher returns. That fuels inflation, squeezing profits and consumers, discouraging spending, and further weakening U.S. economic growth.
The buck probably has further to slip, with the euro rising past $1.60 and the yen likely to hit its highest level since 1995.
But the dollar isn't in free fall. And there's little reason to fear a collapse. The U.S. economy remains structurally sound, though slowed. And if big global investors tried to dump much of their greenback holdings, the rest of their portfolios would crater.
In fact, a healthy rebound is certain: The buck is already below a justifiable level. Something close to $1.40 against the euro makes a lot more sense, given the hard facts.

The big question is the timing of a rebound. It’ll take months ... and a turnaround may be as far off as the end of the year.
The key: Positive U.S. news, or at least a halt in the steady march of negatives. Investors need a reason to quit reacting to every drumbeat by shifting assets out of dollars into other currencies or commodities. Facts are the best antidote to psychology ... the best way to fight fears.
That should come this summer, with stronger third-quarter growth.

Also needed: An attitude adjustment by the European Central Bank. Inflation remains its top concern, not the Continent’s sluggish growth. ECB interest rates won't drop ... and they may even tick higher ... as long as that's the case. And with the ECB and the U.S. Federal Reserve headed in opposite directions, the gap between the dollar and euro will widen. The Bank of England and the Bank of Canada, in contrast, trimmed rates, and the value of the dollar against the pound and loonie has stabilized.
Eventually, inflation worries will ease, soothed by a combination of slow growth reducing demand for commodities and signs of a U.S. pickup.

Meanwhile, the Fed is trapped. It can't halt the dollar’s drop. In fact, its efforts to buoy economic growth only feed the decline. Interest rate cuts make the euro and other currencies more attractive and also increase liquidity, fueling inflation and that downward spiral.
Bottom line: The fall isn’t over, but there’s no need to panic.