Econ--John M. Berry, The Post: "Basis Point + Rate Hike Unlikely"...
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>>> BASIS POINTS
By John M. Berry
Sunday , August 20, 2000 ; H03
The outcome of Tuesday's meeting of the Federal Reserve's top policymaking group, the Federal Open Market Committee, is considered to be, as the bettors at the track would say, "a mortal lock."
In a survey of its clients by Stone & McCarthy, a financial markets research firm, all but one of the 63 respondents said the FOMC would leave its target for overnight interest rates unchanged at 6.5 percent.
But a large majority also said they expect the FOMC to say in its policy announcement, as it did at its June meeting, that "the committee believes the risks continue to be weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future."
Meanwhile, the economic data continued to suggest the economy isn't growing as fast as it was, inflation remains well under control and the federal government's budget surplus keeps getting bigger--all of which is what Fed officials are happy to see.
Tomorrow, Treasury will sell $9.5 billion in three-month bills and $8.5 billion in six-month bills, followed Wednesday by $10 billion in two-year notes. In when-issued trading Friday, the bills yielded 6.28 percent and 6.33 percent, respectively, and the notes 6.27 percent.
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>>> Despite Dilemma, Fed Is Likely To Leave Rates Alone Tuesday
By John M. Berry
Washington Post Staff Writer
Saturday , August 19, 2000 ; H01
Economists have their quarrels. Even when times are good and economic policy appears to be working well.
So it is that even while Federal Reserve policymakers have good reason to be upbeat when they meet Tuesday, they do so amid a continuing debate over why inflation has remained so tame despite unusually tight labor markets.
And while it may sound arcane, it is a debate that matters for American workers because it raises the question of whether the Fed, in an effort to keep inflation under control, may eventually have to raise interest rates further to drive the unemployment rate higher.
The Fed has raised rates six times since June 1999 in an effort to cool a U.S. economy that threatened to overheat and to prevent inflation from taking off. Fed policymakers should be upbeat because it increasingly appears that those actions have worked, combining with other factors to slow U.S. economic growth while core inflation and unemployment remain low.
More and more analysts, including a number of Fed officials, have concluded that, for the second time in five years, good policy and perhaps a large dollop of good luck have enabled the central bank to put the economy on a sustainable, noninflationary growth path. And, they say, the inflation threat appears to have dissipated without raising the specter of a recession.
As a result, for the second meeting in a row, policymakers almost certainly will leave their target for overnight interest rates unchanged.
A large group of analysts also say the Fed won't need to raise rates again any time soon. But some other analysts, such as those at Goldman Sachs in New York who have scuttled their earlier predictions of several rate increases in coming months, still anticipate that the Fed's target for overnight rates, now 6.5 percent, will be lifted to 7 percent during 2001.
For those expecting no change in interest rates Tuesday, the clincher was the report last week that labor productivity – the amount of goods and services produced for each hour worked – at businesses other than farms rose at a 5.3 percent annual rate in the April-to-July period. That meant that the vast majority of the country's growth in the spring quarter came from greater productivity rather than from increases in the number of hours worked. And the gain in labor efficiency was so large, the cost of labor going into each unit of production actually declined even though workers' pay was rising substantially.
Those were unprecedented numbers for the U.S. economy in the 10th year of an economic expansion, and they convinced many doubters that the surge in productivity growth that began a few years ago is not just the result of strong economic growth. Historically, in periods of strong growth, productivity gains have accelerated as businesses get enough orders to use their workers and machines at full efficiency. But later in the business cycle, when economic growth begins to slow, that process usually reverses itself and productivity gains diminish.
This time that hasn't happened, which "supports the view that recent productivity growth is more structural than cyclical," said economist L. Douglas Lee of the consulting firm Economics From Washington. In other words, something fundamental has changed in the economy.
Even with the recent data, many academic economists remain skeptical, arguing that whenever economic growth really slows, productivity growth will slow as well.
For now, however, productivity is still surging, and that has allowed employers to increase workers' pay at a faster pace without raising prices or hurting their profits.
All this good news befuddles some economists. Unemployment has hovered around 4 percent for about a year. According to traditional models, such a tight labor market should have triggered a significant surge in inflation by now. But those older models ceased to track reality very well, and now some are debating their usefulness.
Until a few years ago, many economists believed that a jobless rate of less than 6 percent would lead to pay gains that would force firms to raise their prices and push inflation upward.
For a number of reasons, including demographic changes in the labor force, better-educated workers and increased productivity, there is a consensus that the trigger point for inflation has dropped to between 5 percent and 5.5 percent unemployment. The question is whether, as some economists believe, it has dropped further – to 4 to 4.5 percent.
This trigger point, the jobless rate consistent with a stable inflation rate, is in economists' parlance known as the non-accelerating inflation rate of unemployment, or the NAIRU.
The basic idea is that employers searching for needed workers in a tight labor market will offer higher and higher pay until they get those they need. Then they will pass the higher labor cost on to their customers.
That presupposes, however, that customers can't find another supplier with lower-priced products. Or, put another way, that product markets are just as tight as the labor market.
But in the United States today, that simply isn't true. Many firms producing goods have spare production capacity and face stiff competition from goods made abroad. Meanwhile, prices for many services have been rising less rapidly than in the past, and many – the cost of trading stocks, for example – have been falling. The explosion of Internet use has heightened such competition while also giving firms new ways to cut costs.
So far there has been no acceleration of inflation that can be traced to having an unemployment rate in the neighborhood of 4 percent.
This has left economists debating a number of questions: Is there still is such a trigger point, or NAIRU? If so, is it a point or a range, and where is it? And is it a useful tool for the Fed in deciding interest-rate policy?
On one end are those who think the whole NAIRU idea is obsolete and should be junked. On the other are some who argue that there is a NAIRU and that unemployment is currently so far below it that the Fed eventually may need to raise interest rates to drive up joblessness. In between are those who think that whatever the NAIRU's conceptual merits, there is no specific number so reliable that it should drive Fed policy.
Fed Chairman Alan Greenspan has said many times that he does not use the NAIRU concept in making his decisions about monetary policy.
Vice Chairman Roger Ferguson, in an interview in The Region, a magazine published by the Minneapolis Federal Reserve Bank, explained that he is "in the middle" on the NAIRU debate. Ferguson said he believes there is "a short-term trade-off between resource utilization and inflation" but is not "wed to a specific point estimate" for a jobless rate below which inflation is likely to accelerate.
Numerous other members of the Fed policymaking group have an approach similar to Ferguson's. For some of them, a key difficulty is that most efforts to pin down a figure for NAIRU usually come up with a range rather than a single point, and they find that even the limits of the range are unstable. Under those circumstances, it is hard to use NAIRU as a key indicator in making short-term decisions about monetary policy.
But a few of the current group of Fed policymakers do use a NAIRU approach in their analysis, most prominently among them Federal Reserve Board member Laurence H. Meyer. Meyer was an economic forecaster before coming to Washington and won forecasting awards for results heavily influenced by the NAIRU equations in his econometric model.
In a long string of speeches Meyer has made since joining the Fed, he has repeatedly warned that maintaining a jobless rate lower than about 5.25 percent will eventually lead to compensation payments to workers that will be inflationary. Meyer says that hasn't happened already because of "special factors," including the strength of the U.S. dollar, the Asian financial crisis that began in 1997 and, above all, the unexpected surge of labor productivity in recent years.
Chris Varvares, an economist at Macroeconomic Advisers, the St. Louis forecasting and consulting firm formerly headed by Meyer, said that in their model the rate of increase in wages is affected by several factors in addition to the unemployment level.
One of these is workers' expectations of inflation. The large decline in energy prices and overall inflation in 1997 and 1998 reduced those inflation expectations and thus wage demands, Varvares explained.
The model's inflation predictions are based to a significant degree on what happens to businesses' labor costs per unit of production, which fell in the second quarter of this year. "In the long run, if unit labor costs go up 1 percent, then the price level goes up 1 percent," Varvares said. But when productivity gains surge, wage increases do not generate large increases in unit labor costs, so prices do not go up as much as they have in the past.
Prices have also been affected by the fact that, partly because of the Asian financial crisis, the value of the dollar has been unusually high. That has made foreign goods relatively cheaper in this country compared with U.S.-made goods, which has helped hold down inflation.
With the added competition, American firms haven't been able to raise the prices of the items they sell, and as a result of the productivity surge, their profit margins nevertheless have stayed high because their labor costs haven't gone up.
As Varvares put it, the gap between the actual unemployment rate and the NAIRU "is a good proxy most of the time, but not all of the time" for the state of product markets and whether firms have the power to raise prices.
To Varvares these special factors "look like a decline in the NAIRU," he said, adding: "The Fed is perfectly okay to take advantage of this apparent decline, but it has to be prepared to do what is needed when the special factors are gone and labor costs begin to rise."
Meyer told a Boston audience not long ago that the "major question" for the Fed is whether it can keep inflation at bay by slowing economic growth to a pace, referred to as the trend rate, that will keep the jobless rate from either rising or falling further. "Will [that] get the job done, or [do] we need a period of below-trend growth" that would lift unemployment toward the 5 percent level?"
"If the task is only slowing the economy to trend – because the NAIRU turns out to be close to 4 percent – the task is not as challenging, and inflation will remain stable near current levels. If the NAIRU turns out to be closer to 5 percent, then the task is more demanding, and growth will have to slow to below trend for a while, and inflation is likely to rise somewhat further until the rebalancing is complete.
"If successful, in either scenario, the payoff from monetary restraint will be both to contain the risk of higher inflation and to extend the life of this remarkable expansion," Meyer said.
Some Fed policymakers and Fed watchers have become annoyed that Meyer keeps harping on NAIRU because they fear he is giving the public the impression that the central bank can make its monetary policy decisions based on the behavior of a single economic variable, in this case the unemployment rate.
For instance, when Greenspan was testifying last month before the Senate Banking Committee, Sen. Connie Mack (R-Fla.) asked, "In your view, can we achieve price stability with employment at 4 percent or do we need to move the unemployment rate back higher in order to achieve price stability?"
The Fed chairman replied: "I think the evidence indicating that we need to raise the unemployment rate to stabilize prices is unpersuasive in my judgment.
"It's a major issue in the economics profession, under significant debate. My forecast is that the NAIRU, which served as a very useful statistical procedure to evaluate how the economy was behaving over a number of years, like so many types of temporary models which worked, is probably going to fail in the years ahead as a useful indicator, at least in [being] anywhere near as useful [an] indicator, as it was through perhaps a 20-year period up until fairly recently."
With a thinly veiled reference to Meyer, Mack then asked whether transcripts of the Fed chairman's question-and-answer sessions on Capitol Hill are made available to the other members of the Fed's policymaking committee.
"They are in the public record," Greenspan said, "and if you want to . . ."
Mack interrupted him to say, "I would think it would be helpful if it were made available to the other members of the [committee]."
Then Sen. Evan Bayh (D-Ind.) jumped in: "I gathered from your response . . . you believe that you can maintain price stability . . . with unemployment at 4 percent."
Replied the chairman: "I don't know that for sure. Indeed, in my prepared remarks, I did indicate that that is an open question. I suspect yes, but I must say that the evidence on either side of this question is not yet of sufficient persuasiveness to convince everyone."
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