Barring unforeseen complications from the so-called millennium bug, says Chang Mook Sohn, our state’s economy should remain strong in early 2000. In one of the year’s first economic forecasts, the state’s chief economist and director of the state Economic and Revenue Forecast Council, warns however that several trends, including rising prices and interest rates, should cause businesses and investors to proceed with caution. Here are excerpts from Dr. Sohn’s report:

Productivity. Information technology, which is 6 percent of the state economy, has produced 35 percent of its economic growth over the last five years. Productivity gains outside information technology have been meager. And those will be crucial in extending economic prosperity into the new millennium.

If achieved, high growth and low inflation will continue. All levels of government will be brimming with budget surpluses. The funding of Social Security and Medicare will become smaller problems. The Federal Reserve will be generally accommodative, and financial markets will benefit from low interest rates. Once again, equities will out-perform bonds, boosting America’s standard of living to ever rising heights.

There is a decent chance of maintaining productivity gains in the new millennium. Resources continue to shift from old style manufacturing to information technology, including Internet services and software. In the process, the economy is creating more and higher paying jobs in services. Technological synergy is another factor. America will continue to take advantage of existing technology to cut costs and raise quality; possibilities are endless. Globalization also will promote competition, favoring America’s technological edge.

Economy. The economy is red hot. Consumer spending in the second quarter accounted for over 160 percent of economic growth instead of the more normal 65 percent. There is little evidence that higher interest rates have slowed the economy. Car and truck sales have soared, and new-and used-home sales are at lofty levels. Not to be outdone, businesses have been spending money on plant and equipment, including information technology. Inventories are being rebuilt because the real inventory-to-sales ratio is at the lowest level since 1973. The economic recovery abroad implies that the trade deficit will be less of a drag on the economy in the future.

Nevertheless, the economic temperature should cool early next year. The canary in the coal mine is the stock market. While broad market indices have been moving sideways at a high level, other stocks have been correcting for sometime. With additional help from Fed Chairman Greenspan, the broader averages are likely to go lower, braking consumer spending and economic growth.

The central bank is in a delicate position. Aggressive tightening would cause bear markets around the world, but any hint of an accommodative monetary policy would lead to a renewed speculative fervor in the marketplace.

Eventually, interest rates will rise high enough to slow consumer spending and economic growth.

Y2K is another uncertainty. Most economists agree that Y2K will boost economic growth during the second half of this year and depress economic activities early next year. But, no one is sure of the magnitude of the economic swing coming from Y2K. Furthermore, there is a remote possibility of a financial market freeze around the Y2K season. Investors may choose to sit on the sidelines until uncertainties clear. The Federal Reserve will be ready for any contingencies and abstain from raising interest rates during this period.

Inflation. Inflation concerns abound. The stronger demands here and abroad are putting upward pressure on inflation. Leading indicators of inflation, such as crude and intermediate prices in the PPI, have jumped. The price of crude oil has doubled this year. Fortunately, the higher energy costs have not spilled over into the core inflation rate. The economy is less energy dependent than it used to be. America’s economic output is getting lighter—more service and less goods. Higher oil prices are likely to sap consumer’s pocketbooks and cool the economy. Import prices have been rising due to strong global demand. For example, the price of 64K DRAM chips has more than tripled this year. The weaker value of the dollar has not had much impact on import prices so far. Other than against the yen, the trade-weighted value of the dollar has not depreciated much. However, there is a good possibility of additional dollar depreciation further widening the yawning current -account deficits. Further dollar weakness will raise import prices, allowing domestically competing goods to increase prices.

Cyclically, productivity gains have been ebbing, raising unit labor costs. Given labor shortages from sea to shining sea, businesses are hoarding labor and hiring unskilled labor. This type of cyclical downturn in productivity gains is not unusual; nevertheless, it adds to inflationary pressure. Faced with a margin squeeze coming from higher costs of labor, credit and energy as well as stronger demand, more businesses will be able to raise prices.

To be sure the inflation picture remains good. The core rate has actually fallen. Even though these are lagging indicators of inflation, the Federal Reserve will not be able to raise interest rates aggressively. In the future, it will be a race between labor costs and productivity gains.

In summary, economic growth will remain robust. Early next year, however, higher interest rates, the diminishing wealth effect, higher prices and the lack of pent-up demand for housing and big ticket items should decelerate economic growth significantly. Higher costs of imports and strong demand will push the inflation rate higher, but the overall picture should remain good.

Bonds. Fixed income securities are facing strong headwinds. The economy shows no sign of cooling. Chairman Greenspan has begun to issue economic speeding tickets. To add fuel to the fire, global economic conditions are improving. Foreigners, who own about a third of U.S. treasury securities and almost 20 percent of U.S. corporate bonds, have moved on to greener pastures. Economic recovery abroad means that competition for available savings intensifies. The United States, whose current account deficit as a share of GDP approaches 4 percent, must offer higher interest rates to attract foreign savings. Y2K is adding to liquidity concerns, pushing yield spreads of corporates and mortgages over comparable treasuries to higher levels.

Higher interest rates from tighter monetary policy and rising spreads will brake economic growth and force a meaningful stock market correction, eventually helping bonds. Before yields peak, the bond market must be convinced that a significant economic slowdown is coming. A major setback in equities would be a signal to bid up bond prices.

However, the long-term outlook for bonds is good. The Federal budget surpluses mean reduced supply of treasuries. Productivity gains will remain healthy, maintaining long-run price stability. The wide corporate spread over the treasury will shrink once liquidity concerns associated with Y2K diminish.

Stocks. The slow-motion monetary policy and rosy earnings will support stocks for now. The stock market could be sliding into a bear market. A liquidity squeeze is in progress, and next year the earnings outlook is less certain. Technical indicators, such as the NYSE Advance/Decline indicator, are pointing to troubles ahead. The speed of the fall in equity prices will depend on how Chairman Greenspan decides to play the game of peek-a-boo with the stock market.

Author Chang Mook Sohn is director of Washington State Economic and Revenue Forecast Council.