December 12 1999 BUSINESS NEWS
America's economy cannot cope much longer with
inflation at 3% while house prices are rising at more
than 20%, writes John Makin
US interest rates head for 8%
AMERICA'S "not too hot, not too cold" Goldilocks
economy is getting too hot. The result will be 8% interest
rates by next summer if the overheated, tech-craze-driven
stock market does not crash first.
Asset markets rose in the month leading up to the Federal
Reserve's November 16 meeting in a now familiar ritual that
defuses the usual fear created by the prospect of a Fed rate
rise. This year the markets have sat up and begged for Fed
rate rises because each one is expected to be the last. The
November 16 rise, which the Fed delivered right on
schedule, was viewed as especially delicious because it
completed the "take back" of last year's 75-basis-point
emergency easings and supposedly removed the prospects
of further rate increases. Surely, the reasoning goes, the Fed
will not raise rates at its December 22 meeting, what with
Y2K worries and some desire not to be a total Grinch. After
that, the economy is supposed to slow down obligingly,
removing the need for rises next year.
But since the Fed's November meeting, bond yields have
continued to rise while technology stocks have jumped, too.
The bond-yield rise reflects the fact that the economy is by
no means slowing. During the first half of the year it grew at
about a 2.5% annual rate while during the second half of the
year, as the Fed has been pushing up rates to slow it down,
growth has doubled to a rate of more than 5%.
But, say optimists, not to worry. After all, wages are not
rising, nor is inflation. But while the rises are moderate by
historical standards, inflation is rising. The Consumer Prices
Index (CPI), which began 1999 at 1.6%, hit 2.6% in
October. Wage growth, while not torrid, is between 3.5%
and 4.5% depending on which measure one chooses.
Productivity growth has blunted the inflationary pressure of
wage rises. But the inflation picture is getting worse. Oil at
$25 means CPI inflation will rise by 0.3 points. Meanwhile,
technical changes in the way the CPI is calculated have
reduced measured inflation by 0.3% points over the past
year. Now those adjustments are complete, another 0.3%
will be added to the CPI. These factors alone will add 0.6
points to inflation, pushing the rate above 3% by the spring.
Based on the current 4% level of real interest rates - a high
level because bonds must compete with the torrid stock
market and foreign assets - long-term interest rates will move
to 7% once the reality of 3% inflation sinks in.
There are other troublesome details about inflation the Fed
may ignore at its peril. In calculating the CPI, official statistics
claim the price of housing has risen 2.2% in the past year.
That is because statistics measure the cost of renting, not
buying a house. The cost of buying has risen 8% in the past
year and has recently accelerated. Statistics released in
October showed that the average new-home price rose at a
24% annual rate during the previous quarter.
Asset inflation, higher private wealth from higher house and
share prices, is driving the economy in this vibrant,
investment-led recovery, which is closer to a 19th-century
boom than anything this century. The resulting strain on
output capacity is showing in a rising current-account deficit
that will require still-higher interest rates to induce further
growth in foreign lending to American individuals and
companies, lending that is financing faster American spending
growth. A global configuration of accelerating American
demand growth, driven by higher asset prices, and Japanese
repatriation of foreign investments, has created a situation
with "unsustainable" written all over it.
If the world's biggest borrower, America, has to borrow
more as its current- account deficit rises, while the world's
biggest lender, Japan, wants to lend less as its losses mount
on foreign asset holdings because of a rising yen, real interest
rates have got to rise, probably a full percentage point to
5%. Add a 3% inflation rate and you have market rates of
8%.
The wealth-driven acceleration in spending has emerged
most clearly this year when demand growth has risen to a
level 0.5 percentage points above output growth. The result,
more shortages of the goods and services people buy as
their wealth rises - try to find a housekeeper or a new
S-class Mercedes without paying extra - and a rapidly rising
current account deficit, which now requires America to
borrow $30 billion a month, is the "new economy" analogue
of rising prices in a traditional expansion.
Increasingly rich market players who bid up house prices at
more than 20% a year while buying bonds that are pricing
long-term inflation at 2% are living with a contradiction that
will not persist. Market interest rates of 8% will be needed
to eliminate the contradiction unless a stock-market plunge
cuts spending and the rising current-account deficit. A
currently "unimaginable" 8% level for interest rates - markets
are looking for current rates of not much more than 6% to be
a top - will strain Goldilocks to the breaking point unless the
Bank of Japan forces Japanese lenders back into global
markets by printing more money and pushing the yen back
down, thereby helping to reflate Japan and the global
economy.
The Fed and the Bank of Japan need to change places on
the easy-tight spectrum of monetary policy and it is the Fed
that needs to move to the tight side. But do not look for
either to move much until Goldilocks sweats some more and
markets push American interest rates toward 8%.
John Makin is an economist at the American
Enterprise Institute
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