THREAD ---A good article on interest rates and inflation from this weekends from Barrons :
ay 31, 1999
The Fed's Rivlin to Bond Market:
Calm Down, It Really Is Different This Time
By WILLIAM PESEK JR.
It's the most intriguing question in modern economics: Can the United States'
rule-shattering streak of torrid growth, minuscule inflation and roaring equities
continue? Nowhere is it getting more attention than at the Federal Reserve
Board, which nowadays might be thought of as the world's most powerful
think tank. Its braintrust of Ph.D.s is struggling to figure out what's going on in
the economy and, more importantly, how to maintain its enviable
performance.
At a central bank crowded with traditionally-minded economists, Alice Rivlin
has been the most vocal keeper of the things-really-are-different-this-time
flame. While others argued that there are limits to how fast the economy can
grow without overheating, Rivlin found comfort in an alternative scenario: One
where once-in-a-generation gains in productivity, technology and global
competition are taming inflation.
In recent years, the Fed's No. 2 official has been right. With the blessing of
her boss, Alan Greenspan, Rivlin worked to get other policy makers to resist
the urge to step on the brakes by boosting rates.
But recent news that the consumer price index surged a hair-raising 0.7% in
April had Wall Street thinking the Fed will abandon its experiment to see if the
economy is less prone to imbalances than in the past. The Fed's adoption of a
bias toward tightening seemed to validate such fears.
Unfazed, Rivlin has a message for the
bond market: Calm down. "Except for
the recent CPI number, we've had
good growth with very little inflation,"
the Fed vice chair said in a recent
interview with Barron's. "One month
of statistics doesn't tell you anything
and so I'm always reluctant to make
much of it."
Until further notice, the experiment
continues. Rivlin downplayed reports
that the central bank's tolerance for
above-trend growth and declining
unemployment has run its course. Rather, policy makers continue to be
impressed -- and perplexed -- by what's occurring in the economy. Rising
productivity and increasing competitiveness in the global marketplace, she
argued, still hold the promise of restraining the kinds of upward price
pressures that prompted the Fed to take away the punchbowl in past business
cycles.
Even if some prices heat up, Rivlin thinks an outburst of inflation is highly
unlikely. And if the April CPI figures were in fact a signal that inflation is
heading higher, she believes forces at play in the economy will keep prices
from taking off rapidly. While she wouldn't say, Rivlin doesn't seem inclined to
vote in favor of higher rates.
Other voting members of the Federal Open Market Committee may disagree.
But in her heart of hearts, Rivlin doesn't buy the argument that the
extraordinary U.S. performance of recent years is a fluke. Instead, the period
raises fundamental questions about the relationship between employment and
inflation, as well as how the Fed will interact with the economy going forward.
The fact that inflation remains so tame at a time when unemployment is sliding
and the pool of available labor is shrinking can't be easily explained away, she
explains.
Meanwhile, Rivlin argues, it's still likely that rigid employment conditions,
rather than fueling inflationary gains in wages, are fostering a new kind of
discipline in Corporate America. Her hypothesis: Low unemployment is
actually restraining upward wage pressures because it's forcing more
managerial innovation and sparking more investment in training unskilled
workers. As such, employers are getting more in return for higher wages.
While economists aren't paying much
attention to the phenomenon, Rivlin
notes that businesspeople are. Efforts
begun in the early 'Eighties are paying
off. Beyond that, companies are
competing in an age when half of the
global economy is experiencing
sluggish growth. In the rest of the
world, the Internet is eating into
pricing power. Against that backdrop,
employers see higher productivity as
perhaps the only road to beefing up
profits.
"Instead of being a negative for productivity, tight labor markets are a positive
because they've forced us to become more innovative," she says.
It's an intriguing theory, one that's won respect in some quarters of the
economics community and invited angry cynicism from others. It's also elicited
varying responses within the Fed system. To some, these revolutionary
changes have simplified the Fed's job, taking the onus off policy makers to
engineer politically sticky rate hikes. To others, the uncertainty has clouded
the central bank's ability to assess where inflation is heading six to 12 months
down the road. Some in this camp secretly worry that the Fed is falling behind
the curve.
Clearly, recent trends are only widening that philosophical rift. "The notion
that the economy was going to settle down to a lower growth rate is one
we've all had for a long time and it doesn't seem to be happening yet," Rivlin
says. "We keep being surprised on the upside."
So far, those who believe there's a New Economy are looking pretty good.
Growth, after all, zoomed along at a revised 4.1% in the first quarter, while
employment costs rose only 0.4%. Explaining this disconnect was the 4%
surge in productivity at non-farm businesses. Indeed, it's increasing worker
efficiency that's prompting Wall Street to price in greater profits -- after taxes,
they rose 4.3% in the first quarter -- and keep inflation under wraps.
Warning Flag
But the April CPI data served as a yellow flag that trouble may lie ahead. The
gain in the overall index far exceeded economists' expectations, while the core
rate, which excludes food and energy costs, jumped an equally troublesome
0.4%. Fed officials typically don't react to one piece of data, a point Rivlin
made quite clear during our conversation. But the price numbers provided the
most alarming evidence to date that the economy may be stretched beyond its
growth potential. "Essentially what the bias [shift] means is that we're
concerned about inflation but we haven't had any yet," she says.
Others are more concerned.
Single-handedly, says one senior Fed
official, the CPI data stirred fear that
the "new paradigm" in the U.S.
business cycle was a mirage, caused
by an odd confluence of one-time
factors -- falling commodities, a
strong dollar, recessions abroad --
rather than permanent changes in the
way the economy operates.
At the same time, while inflation
numbers remain benign, some at the
Fed remain concerned about the
economy's relentless growth rate, the
official says. Similar thoughts sent bond yields higher again last week,
spooking the stock market. Late Friday, the yield on the 30-year Treasury
bond was 5.84%, up from 5.77% a week earlier. But fears of a Fed move
were most apparent in the two-year T-note, which backed up to 5.43% from
5.30% the previous Friday, where it stood last August and far above the
3.86% low last October.
Most Fed watchers aren't expecting a rate hike at the FOMC's June 29-30
meeting. But if other data confirm the trend, analysts think the central bank is
likely to engineer its first hike in short-term rates since March 1997. If policy
makers plan to tighten in June, they have some work to do in warning the
markets. Fed chairman Greenspan could use a speech on Wednesday to set
the stage for higher short-term rates.
The key reason the central bank hasn't acted is fear of meddling with a New
Economy that policy makers are just beginning to understand, Fed officials
say. But equally important is the growing consensus that monetary policy
works faster now than in the past. So if prices perk up, some at the Fed feel it
can halt the increases rather quickly.
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