Fed Unlikely to Alter Course--So says the Influential
Fed watcher John Berry, who writes for the Washington Post.
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By John M. Berry
Washington Post Staff Writer
Wednesday, April 5, 2000; Page E01
Looking out over the roaring U.S. economy, Alan Greenspan looks a little like a wizard who has lost his powers.
In the nine months since the Federal Reserve chairman and his colleagues began raising interest rates to throttle back economic growth, its pace has actually sped up--hitting an extraordinary 7.3 percent annual growth rate in the last three months of 1999.
Some analysts have begun to ask whether the Fed's interest rate tools still work in an economy being powered by a high-tech revolution. But those tools have always worked with a lag of a year or more, so the lack of much response so far proves little one way or the other, according to many Fed watchers.
And if higher interest rates have lost any of their potency, it may not matter very much. According to public statements by numerous Fed officials, there is broad agreement among them that they will keep raising rates until growth slows to a more sustainable pace to make sure inflation stays under control.
The Fed has raised its target for overnight interest rates by a quarter of a percentage point five times since June. Yet the economy has kept sprinting, analysts have kept raising their estimates of corporate profits and--until the last few days at least--investors have kept pumping money into the stock market. As stock prices have risen over the past several years, so have American household wealth and consumer spending, precisely the cycle that Fed officials want to interrupt to slow growth before it fuels more inflation.
The very sharp drop in prices of many Internet stocks in the last few trading sessions isn't likely to cause the Fed to hold off on additional rate increases. By the market's close yesterday, the Nasdaq composite index had dropped only back to where it was at the beginning of February. The Standard & Poor's 500-stock index remains close to its record high set just two weeks ago. And the index the Fed watches most closely, the Wilshire 5000, which includes all but a very small share of all publicly traded U.S. stocks, is still up for the year.
"For the Fed to be done [raising rates], U.S. economic growth must moderate," said Bruce Steinberg, chief economist at Merrill Lynch & Co. in New York. "There is scant evidence of any moderation as of yet. But leading financial indicators of economic activity point to slower growth by the second half of 2000."
However, the lack of concrete evidence of slowing has some analysts--and indeed some Fed officials--suggesting the Fed needs to move more quickly. At a February policymaking session, some Fed officials argued for a half-point increase rather than a quarter point, according to recently released minutes of the meeting. That suggestion will undoubtedly be on the table again at the next meeting on May 16, but most Fed watchers think Greenspan and a majority of the officials will stick with the more gradual approach.
Robert Parry, president of the San Francisco Federal Reserve Bank, explained this approach last week by saying that the situation is different from that during the last round of Fed tightening in 1994 and early 1995, when the central bank raised rates by half or even three-quarters of a percentage point at a time. "We were more confident about the old relationships between the growth of the economy and the level of the unemployment rate and what was happening with inflation," Parry said. ">b>I don't have that confidence now. Right now I can point to the last three or four years of my forecasts and know that I have been wrong every year. If that's the case, then I'd better be cautious.
"I think the Fed has embarked on a cautious policy and I think that it's the appropriate policy," Parry said.
When the Fed moves to curb growth by raising interest rates, almost invariably there is a period when the central bank looks ineffectual. Rates rise and borrowing costs more, but initially no one seems to notice much in the heat of a booming economy. Eventually, though, monthly loan payments rise enough that some consumers and businesses pull back on purchases and investments, and growth slows.
"Monetary policy operates with a lag of about a year," Steinberg said. "Since the first move of the current tightening cycle only occurred last June, it is only in the second half of 2000 that monetary policy could be expected to affect the economy."
That lag occurs partly because the Fed usually raises rates relatively gradually. During this period of apparent ineffectiveness, some analysts frequently argue that for one reason or another the economy, or some parts of it, aren't really affected by higher rates.
This time, one argument is that the high-tech companies whose stocks have been soaring borrow little money, so their costs don't go up along with rates. However, despite their rising value, such companies represent only a tiny share of the economy when measured by production or jobs. At this point, analysts generally are not suggesting that rising rates have been responsible for the recent pullback in the Nasdaq.
Still, there isn't an example in history of the Fed failing to slow growth when it was determined to do so. The reality is that higher rates do matter, and that if they get high enough they matter a lot.
When the Fed began the latest round of tightening, someone with a $10,000 home equity loan with an interest rate equal to the prime lending rate of 7.75 percent was paying roughly $62.50 a month in interest, or $750 a year. Now the prime is at 9 percent, up the same 1.25 percentage points as the Fed's target for overnight rates, and that interest payment is $75 a month, or $900 a year. After the next Fed policymaking session, the target and the prime almost surely will go up another quarter point, and that monthly interest payment will be just over $77, with the annual amount up to $925.
A host of small businesses, whose bank loans are typically also tied to the prime, have faced a similar series of increases in borrowing costs. A typical medium-ranked corporation with a BAA bond rating that could issue bonds yielding around 8 percent in June is now paying about 8.35 percent. And rates on new 30-year fixed-rate home mortgages are up to about 8.5 percent from less than 7.75 percent in June, an increase that has added nearly $100 to a monthly payment on a new $150,000 mortgage.
"Over time people will find that rates are high enough to matter," said economist James Glassman of Chase Securities Inc. in New York.
About the only place rates are not up very much is on the U.S. Treasury's 10-year notes and 30-year bonds, whose yields are little changed compared with last June. That's because the Treasury is issuing ever fewer new notes and bonds as the size of the publicly held national debt declines. With the supply of such securities likely to shrink over time, investors are snapping them up, driving prices up and yields down.
Glassman also noted that interest rates are already particularly high compared with the low underlying U.S. inflation rate. If volatile food and energy items are excluded, consumer prices are up 2 percent or less over the past year, which means that on an inflation-adjusted or "real" basis, even the Fed's 6 percent target for overnight rates represents at least a 4 percent real rate. Similarly, an 8.5 percent mortgage rate means that a homeowner is paying a 6.5 percent real rate.
"With inflation so low, wages aren't going up all that fast," certainly not enough to equal these interest rates, Glassman said.
Stephen D. Slifer, chief U.S. economist for Lehman Brothers Inc. in New York, said recent gains in productivity mean that to exert the same degree of restraint on the economy as during the last round of Fed tightening, real rates will probably have to be raised higher than they were then. In that round, the Fed stopped with overnight rates at 6 percent, the same as today's level, and economic growth came almost to a standstill in the spring of 1995.
However, Slifer thinks that because productivity gains have raised the economy's sustainable growth rate substantially, it will take a target of around 6.75 percent to apply the same braking power as in 1995. That would take three more quarter-point increases, which Slifer now predicts will occur. But he hastens to add that with the economy's strong momentum, that much braking would slow growth but not bring it close to zero.
Merrill Lynch's Steinberg agrees that real rates are around 4 percent, and "that's high. The last recession was triggered by a real [overnight] rate of just over 5 percent. In other words, real interest rates are either at or heading toward levels that should soon start to slow down even the juggernaut U.S. economy."
Mickey Levy, chief economist of Bank of America Corp. in New York, pointed to another reason that growth hasn't slowed much: the interest rate cuts the Fed made in the fall of 1998, when world financial markets seized up in the wake of a default by the Russian government on part of its debt. "We are only half a percentage point higher [on overnight rates] than we were in early 1998," Levy said. "Between then and now, the Fed pumped in a lot of money, and now it has to take some of that away."
Bill Dudley, chief economist at Goldman Sachs & Co. in New York, points to one irony in the response of investors and the economy itself to what the Fed has done so far.
"Greenspan is so trusted" that longer-term rates haven't gone up as much as they normally would because everyone believes that the Fed will keep inflation under control, he said. "That makes the Fed's job more difficult and means it will have to push rates up more. Neither the bond nor the stock markets are helping at all." |
