Speaking of the devil... t2K - a followup to my post...
nytimes.com
<<Focus Shifts to the Central Bank's
Long-Term Agenda
By RICHARD W. STEVENSON
WASHINGTON -- Is it 1994 all over again, the beginning of a
prolonged series of interest rate increases intended to wring
inflationary pressures out of an economy that is threatening to
overheat?
Or is it 1997, when the Federal Reserve bumped interest rates up once just
to let everyone know it was on the case, and then let the economy go on its
rip-roaring way?
Economists and investors are all but certain that the Fed will push its
benchmark lending rate up by a modest quarter of a percentage point next
week in a pre-emptive strike against the possibility of resurgent inflation.
And while neither 1994 nor 1997 provides a precise analogy for the current
situation, what everyone wants to know is whether the central bank will be
content with a tap or two on the monetary brakes to reassert its
inflation-fighting credibility, or whether the Fed will embark on a more
vigorous series of rate increases.
Alan Greenspan, the Fed chairman, hinted in congressional testimony last
week that the central bank itself did not know yet how far it would have to
go to deny inflation a foothold, and would decide based on how the
economy performed in coming months.
"What we try to do is make the best judgments we can at the particular
time that we meet, or if it is relevant, between meetings," Greenspan told
the Joint Economic Committee. "I don't recall ever having a sense that we
are going to do a series of increases or decreases."
Still, assuming no significant acceleration or slowdown in economic activity
over the next few months, the odds now seem to favor an in-between
scenario in which the Fed tightens its benchmark federal funds target rate
by a quarter point next week, to 5 percent, and then perhaps once more by
another quarter point later in the summer, before shifting back into neutral.
Although the economy has repeatedly proved to be far stronger than
analysts predicted the last several years, many economists think the
combination of two modest rate increases by the Fed, combined with the
rise the last few months in long-term rates set by the bond market, should
be enough to slow the economy to a point where inflation recedes as a
threat.
"The view the market has now, and we agree with it, is that another rate
hike is coming, but that this round of tightening will not have to be
aggressive," said James Glassman, an economist at Chase Securities in
New York. "The market now seems priced for another quarter-point move
in August, and that's it for a while until we see how things work out."
The judgments made by Greenspan and his colleagues in coming months
will be among the trickiest they have faced in several years. While they
now appear comfortable shifting their attention from financial conditions
around the world back to the situation in the United States, Greenspan in
particular will have to balance his oft-expressed belief in the
inflation-dampening power of increased productivity against his fear of
endangering the domestic price stability of the last few years.
For all the obvious comparisons, policy-makers may draw little guidance
from their experiences raising rates in 1994 and 1997. While the Fed, for
example, also acted in 1994 to head off inflation before it took root, it
started at a time when monetary policy was far looser than it is today. The
Fed funds rate stood at just 3 percent when, in February 1994, the central
bank made the first of seven increases that over the course of a year
doubled the rate to 6 percent.
The Fed's immediate goal this time around is not so much to squelch
inflation -- there is almost no inflation -- as it is to head off the forces that
can create inflation. Although a rebound in oil prices has helped push the
Consumer Price Index up somewhat this year, the one-month spike in April
of seven-tenths of a percent is now widely viewed as an aberration, and by
most measures prices remained stable last month.
"For the time being, inflation remains exceptionally quiescent, with the
year-over-year increase in consumer prices, excluding food and energy,
falling to 2.1 percent, the lowest rate in more than 30 years," economists at
Goldman, Sachs told clients in a report this week.
The Fed's somewhat more nebulous target is demand for goods and
services, which has been running at consistently robust levels. In the view
of most Fed officials, the combination of strong demand growth and
extremely low unemployment is potentially volatile. Left unchecked, they
say, strong demand will ultimately force companies to bid up wages to find
the employees they need in a dwindling pool of available workers -- and
rising wages could ultimately lead companies to raise prices, setting off an
inflationary spiral.
But the trick for the Fed will be to temper demand without setting off a
destabilizing rout on Wall Street, where ever-higher stock prices have left
many consumers feeling flush and willing to spend. And the Fed will have
to act in the face of opposition from some members of both parties who
say the central bank is sacrificing jobs and wage increases in pursuit of a
problem that does not exist.
"If we make policy on the basis of the fear of inflation, we will inevitably
forgo the very benefits that have been so crucially important to working
families these last three years," John Sweeney, the president of the
AFL-CIO, told a news conference on Capitol Hill Thursday.
One way that Fed officials and economists generally are framing the
debate is to compare the economy and monetary policy last summer to
conditions today.
Last summer, before the global financial crisis became acute and began
threatening markets in the United States, the Fed's benchmark federal
funds target rate stood at 5.5 percent -- three-quarters of a percentage
point higher than today's -- and the central bank was leaning toward
pushing rates higher. Only the need to stabilize markets at home and
around the world led the Fed to reverse policy and cut rates three times in
the fall in quarter-point increments.
Now, with the global crisis apparently past and demand from both Europe
and Japan likely to pick up, one camp of economists makes the case that if
a Fed funds rate of 5.5 percent or higher was appropriate last summer, it is
appropriate now.
After all, unemployment, which was 4.5 percent last August, has declined
to 4.2 percent. Growth in gross domestic product, which was 3.7 percent in
the summer quarter last year, jumped to 6 percent later in the year and
remained a torrid 4.1 percent in this year's first quarter. And the Dow
Jones industrial average, which stood at around 8,500 just before the
financial crisis flared last August, closed Thursday at 10,534.83, a jump of
nearly 24 percent.
John Makin, an economist at the American Enterprise Institute, said a
series of rate increases now could be seen as a continuation of a tightening
policy that began not last summer but as far back as March 1997, when
the Fed pushed rates up by a quarter point, to 5.5 percent. Only the initial
outbreak of the Asian crisis in the summer of 1997 and the steady spread
of financial problems around the world the next year, he said, kept the Fed
from tightening further in that period.
"This string of unprecedented financial shocks can be viewed as an
interruption in a Fed process of tightening in response to strong U.S.
demand growth initiated over two years ago," Makin said in a recent
report. "Given that it was on track to tighten in spring 1997, the Fed would
be reasonable to contemplate taking back the 75 basis points of easing last
fall in response to systemic risk."
But another group of economists, influenced in part by Greenspan, points
out that the economy today is not the same as last summer's -- that the
most significant changes since then are an increase in the growth of
productivity, or output for each hour worked, and a deceleration in the pace
of wage increases despite the declining unemployment rate.
Both factors suggest that the economy is less inflation prone than it was
last summer. The rise in productivity means companies can offset cost
increases with improved efficiency rather than price increases. And the
drop-off in wage growth suggests that workers are not using the leverage
of a tight labor market to win big raises, possibly because of a deeply
ingrained fear that they could lose their jobs to global competition and
possibly because employers are compensating workers with
performance-based bonuses.
"There's less skepticism now than last summer about the favorable inflation
outlook," Glassman said. "The more we see what's happening around the
globe, and the more we see what's happening with productivity, the more
open-minded people are about the economy's ability to sustain low inflation.
That argues that the Fed does not have to push rates back up to where
they were."
Greenspan made clear in his congressional testimony last week that his
primary concern is not the heady level of the stock market, as worrisome
as that is to him, but the possible effect of continued strong domestic
demand on wages.
But it is difficult to make an ironclad case these days that rising wages will
lead to a general increase in prices. So far, productivity gains have more
than offset rising wages and other costs. The problem, as Greenspan has
noted repeatedly, is that policy-makers cannot count on productivity growth
to continue to improve forever. At some point, the productivity growth rate
could level off, or wage growth could accelerate, and the seeds of inflation
would then take root in the form of rising cost structures within companies.
Yet even if that happens, it is by no means certain that companies will be
able to pass on their higher costs to consumers because competition is so
intense that producers have proved to be willing to give up profits to
maintain or gain market share.
Moreover, there is little evidence of any acceleration in wage increases in
the first place.
"The pressure on labor costs is milder than we thought it would be, despite
the fact that the economy is stronger," said Richard Rippe, an economist at
Prudential Securities in New York.
Rippe said there were other reasons why the Fed was unlikely to raise
rates aggressively the rest of the year. The domestic economy is already
showing some tentative signs of slowing.
While the global crisis appears past, the recoveries in many countries are
fragile and could be hurt by higher rates in the United States. And Rippe
said the Fed would like to avoid driving the value of the dollar higher, which
would be likely if interest rates in the United States rose substantially.
While a stronger dollar would help contain inflation by holding down import
prices, it could also lead to a further expansion of the trade deficit, which is
not yet a major problem but could ultimately become one.>>
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