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Politics : Idea Of The Day -- Ignore unavailable to you. Want to Upgrade?

To: Al Serrao who wrote (17800)	4/12/1998 12:22:00 AM
From: IQBAL LATIF	Read Replies (1) \| Respond to of 50167

Al- You once asked me about interest rates and growing economy I wanted you to see this excellent article in FT. GERARD BAKER: Great growth mystery The bull stock market in the US may explain why there has been no slowdown in the economy For the past year, a fierce debate has raged among economists about whether or not the Federal Reserve should raise interest rates to prevent an inflationary overheating in the supercharged US economy. Proponents of an increase in rates have argued that sooner or later, the current pace of growth, at nearly 4 per cent for most of the past year and well above the long-term potential rate, will prove unsustainable. For all the talk in recent months of an Asia-induced slowdown, the actual effects on the US of the turmoil in that region will be negligible, they say, and certainly not enough to slow the powerful momentum in the domestic economy. Opponents have argued either that the US had in fact moved on to a higher plane of sustainable growth as a result of fundamental changes in the economy; or that a combination of factors, especially the Asian effect, would bring growth back to trend. Yet while this controversy has been played out in familiar academic and financial circles, a curious thing has happened. The Fed has in fact been steadily tightening the monetary screws on the economy. Not by its own action - it has not actually changed the Fed funds rate in the past year - but by its inaction. While nominal rates have been unchanged, the plunge in price inflation has meant that real interest rates have been rising steadily. Real interest rates are nominal rates minus expected inflation. A rough but reasonable proxy for expected future inflation is the current inflation rate. Since March 1997 when the Fed funds rate was raised to 5.5 per cent, the consumer price index has dropped from a year-on-year rate of 2.8 per cent to the latest figure in February of 1.4 per cent. That suggests that not only have real rates of interest risen by nearly 1.5 percentage points, but that they have reached a level - about 4 per cent - which by the standards of the past 20 years would be expected to squeeze the life out of even the most robust economy. Alan Greenspan, the Fed chairman, drew attention to this tightening by stealth in testimony to the Congress in February, in which he said: "[The Fed] took some comfort in the upward trend of the real federal funds rate over the year . . . such additional restraint was viewed as appropriate given the strength of spending." But troubling for Mr Greenspan is that this tightening seems to have had almost no effect on the economy. Even allowing for the fact that interest rate increases take some time to work through to consumers and producers, the squeeze should have produced a slowdown by now. During the past 30 years, real short-term rates have averaged about 2 per cent. Anything above 3 per cent is considered aggressively tight. But with real short-term rates rising last year towards 4 per cent, growth last year was still frenetic - just below 4 per cent - and has continued at about the same pace this year. What is going on? Some economists say the emphasis on the Fed's role is overstated. While the central bank may have presided over a rise in real short-term interest rates in the past year, more important for real demand in the economy is the level of long-term rates. The yield on 30-year Treasury bonds in the past year has declined from almost 7 per cent, to a little over 5.5 per cent. Since it is these rates that set mortgages and corporate and consumer bank borrowing costs, and since, after the decline in inflation, there has been a slight fall in long-term rates, much of the mystery of the continuing growth is removed. But there are flaws to this argument. The yield curve certainly has flattened in the past year, but, by historic standards, real bond yields remain very high. In the period since 1960, the real yield on the 30-year Treasury has averaged about 3 per cent, against the current 4 per cent. What is more, as inflation has declined, real bond yields are higher than they were at the end of 1996 - since when growth has been accelerating. Another view, advanced recently by Ian Shepherdson, the chief economist at HSBC, the investment bank, is that higher real rates have been rendered nugatory by a form of "money illusion". Even though real rates are high in historical terms, nominal rates are low. Consumers and companies still have half a mind in the high-inflation 1970s and 1980s, and see interest rates of 6 per cent or so as attractive for borrowing. On this view, the US is heading for trouble. If much of the borrowing of the past few years has been predicated on assumptions of future price and earnings growth of 1980s proportions, borrowers will have difficulty repaying their loans. But there is another factor that might explain the robustness of demand in the face of apparently the tightest monetary conditions in a decade: the stock market. The sharp rise in equity prices in recent years has come when the stock market is more important to more Americans than ever. Roughly half the population now owns shares and they have seen an enormous increase in their wealth during the past five years. According to Bill Dudley, US economist at Goldman Sachs, this increased wealth - especially in the past year - has more than outweighed the effects of higher real borrowing costs. Mr Dudley has constructed an overall financial conditions index that estimates how tight or loose money really is. On standard definitions - combining short and long-term interest rates and the currency - conditions have tightened markedly in the past year. But add in the movement in stock prices, and the index in fact shows that the financial stance has become easier. This seems intuitively correct. Recent official figures show a further decline in savings rates - a sure sign that Americans feel more secure about their present and future wealth. These factors emphasise the familiar danger that exists if equity prices fall. The stock market effect would then reinforce tight monetary conditions, causing a sharp contraction in demand and forcing a dramatic easing in monetary policy. With every new landmark passed by a surging bull market, the policymakers' headaches grow more intense.