YOU DECIDE: HOW ARE THE ECONOMIC FUNDAMENTALS?

The common refrain from many economists and analysts after the recent stock market plunge was, "don't worry, the economic fundamentals are good." Well, what exactly are these economic fundamentals they're referring to, and are they indeed "good?"

Stock values ultimately depend on the earnings of companies. Company earnings, in turn, depend on the state of the economy. Thus, economic fundamentals like the rate of growth in the economy, the inflation rate, and the levels of interest rates are key determinants of the ups and downs of the stock market.

Recently, these economic fundamentals have been quite good. The economy has been growing, jobs are being added, and interest rates have been at moderate levels with no recent major rises.

But perhaps the best economic fundamental has been the low inflation rate in the economy. Retail inflation, measured by the Consumer Price Index, is rising at an annual rate of 2.1 percent this year, lower than last year's 3 percent. Average prices for businesses have actually fallen in 1997.

The stock market, however, doesn't look at the past, but looks to the future. In other words, the stock market doesn't ask, "what has the economy done for me lately," but "what will the economy do for me in the future?" So it's really the economic fundamentals of the future that will help determine the stock market's path.

Of course, any forecast of the future is just that a forecast which has some chance of being wrong. That said, most economists are predicting a good economy for the near future. The economy will continue to grow, although somewhat slower, and interest rates may be slightly higher. The inflation rate will also be "well-behaved," although perhaps edging somewhat higher to between 2.5 and 3 percent.

There are certainly always potential problems in the economy, and today is no exception. The two biggest threats for the economy are consumer debt loads and a rekindling of inflation.

Consumer installment debt as a percentage of income is near an historic high. The good news is that most of the debt is owed by middle and high-income households who have an ability to make the payments. However, the bad news is that any "shock" to the economy, like an international crisis, could scare consumers and cause them to slow their rate of spending. And, any major slowing of consumer spending can lead to a general economic downturn. Of course, the stock market doesn't like economic downturns.

Significantly higher inflation could arise from faster rising wages and salaries. This year, a tight labor market caused wages, salaries, and benefits to rise 1.4 percent, after accounting for inflation. In 1996, this increase was only 0.6 percent. By itself, this acceleration in wages, salaries, and benefits would have led to a faster inflation rate in 1997 than in 1996.

Instead, 1997's inflation rate was lower. A faster growth in wages, salaries, and benefits didn't lead to higher general inflation because average worker productivity rose a very strong 2.8 percent during the year. That is, workers easily earned their higher compensation in 1997 by working harder and smarter. This allowed businesses to pay workers more without raising prices.

One of the big questions for the future is whether worker productivity will continue to register big gains. Many analysts think not. If worker productivity stagnates or rises at a significantly slower rate, business costs could rise much more rapidly, and this could generate faster inflation. In this case, the Federal Reserve would likely step in, raise interest rates, and slow the economy.

So although the economy looks good now, there are always possible bumps in the road ahead. You decide if these bumps can be avoided, or if they are pitfalls that can't be missed.

Dr. Walden is a professor and North Carolina Cooperative Extension Service specialist at North Carolina State University.You Decide endeavors to provide a balanced look at a variety of economic, public policy and personal finance issues. This feature is provided every two weeks by Dr. Walden and the Department of Agricultural Communications at NC State University.