Higher rates are needed to cool America's boom:
THE MARKETS are tending to assume that last week's 25 basis point rate increase by the Federal Reserve will be the last for a long time. With inflation seemingly tamed and with the two looming Y2K problems - electronic and electoral - they believe the Fed will stand still.
So what will really happen? The answer is that nobody knows, not even Alan Greenspan, the Fed chairman. We are in a new era. As Greenspan has said, this may be the kind of technological supply shock that we experience only once or twice in a century. That leaves a shortage of information with which to create a new model of the ecomomy.
But there are three guide posts that tend to work fairly well in any era: the labour market, the current account and the yield curve. They work because they represent physical or financial constraints on the ability of the economy to expand. At the moment each is signalling that the Fed's latest move is not its last.
Consider first the labour market. The economy is fast running out of workers. The number of unemployed people without college experience has fallen from 2.7m to 2.1m in the past four years. Seventeen years ago, when this long expansion began, there were 8.5m such unemployed workers.
With nearly full employment among those with some college education, a focus on those without is appropriate. With 250,000 jobs being created each month but the workforce growing at only 150,000, this market is less than a year away from being as tight as that for college-trained workers. The labour-market constraint in America is ceasing to be a hypothetical one and fast becoming as solid as a brick wall. Of course, markets tend to create an airbag of soaring labour costs to cushion the economy before it hits a brick wall. The most recent employment cost index suggests that the airbag is beginning to inflate.
Second, there is the mushrooming current account, which shows that the American economy is facing a savings constraint. The current expansion is fuelled by borrowing from abroad - at the rate of $300 billion a year. On present trends of saving and spending in the private economy, this deficit will double in the next 18 months.
A monthly trade deficit of $50 billion is inconceivable. But acknowledging that is like admitting that the American economy can't go on like this. Of course, capital flows do not pose a physical constraint in the same way as a shortage of workers. There is no brick wall ahead, but there is an airbag - the exchange rate.
At some point, foreign creditors will demand that America show some ability to finance itself. If this does not happen through domestic actions, the exchange rate will fall until American goods are sufficiently competitive, and foreign goods sold in America sufficiently dear, for the trade deficit to shrink.
While possible, such an exchange-rate shock must be avoided for the sake of global stability. Unfortunately, that brings us back to the Fed, which must maintain the international credibility of the American dollar.
Finally, consider the yield curve. If we really are in a new era then we should expect the yield curve to resemble that of the Wicksellian world of the natural rate of interest. In this new era of ours, with inflation tamed, there should be no risk premium associated with the term of lending to credit-worthy borrowers. Investors should expect that future inflation will be much the same as today. So they should not demand a premium to lend (by buying, say, a Treasury note) for five years instead of for three months. The markets today demand such a premium. This means that we are not in a new era or that interest rates are below their "natural" level.
Nobody knows what interest rate is needed to slow down the growth in the demand for labour until it matches the rate of growth in supply. Nor can anyone tell what it will take to equalise the domestic supply and demand for savings, or what the "natural" rate of interest might be - and that includes Greenspan.
That is why the Fed will move in small increments, trying not to overtighten and thereby undermine a still fragile global financial system. A corollary of this is that the Fed does not want the market to start anticipating the degree of tightening. It must establish an equilibrium without a painful overshoot. Doing so requires that the markets expect that its last move is truly the last or that, at most, no more than one more tightening lies ahead.
Greenspan and his colleagues have mastered this aspect of market psychology. They are not being deceptive, for they themselves do not know whether any move will be their last.
The odds have to be that the latest rise in interest rates is not the last. At the very least the Fed will restore the 75 basis points by which it eased last year.The question then will be, is that enough? What the labour markets, foreign-exchange markets and yield curve seem to be telling us is that the most likely answer is no.
Dr Lawrence B Lindsey is the Arthur E Burns Chair in Economics at the American Enterprise Institute for Public Policy Research
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