Interest rates will rise with a vengeance

THE SUNDAY TIMES May 7, 2000

The Federal Reserve's policy committee meeting is only some 10 days away and a full-scale Greenspan-watch has begun. The consensus is that Greenspan and his colleagues will raise interest rates by as much as half a percentage point, to 6.5%.

The traditional inflation indicators have not been scary, giving new-economy advocates plenty of ammunition for their argument that rising productivity will keep costs down and increased competition will prevent cost increases that do materialize from being passed on in the form of higher prices.

But now the economic signs all seem to be pointing to the need for an increase in interest rates - and one larger than a puny quarter of a point, the Fed's magnitude of choice for the five increases it has instituted since last June. The economy is booming, productivity gains are slowing, labor costs are rising and price pressures are becoming visible.

Let us start with the economy and the most recent reports on various sectors. Despite the fact that mortgage rates have risen, with 30-year fixed-rate mortgages now at 8.28%, about two points above their October 1998 low, builders are selling new homes as fast as they can construct them. The March increase of 4.5% was the largest in more than 18 months. So far this year, sales are up 9.6% and prices of new homes are up by 6.5%.

Car sales are every bit as buoyant. The industry sold 9% more vehicles in April than it did in the same month of red-hot 1999, with Ford reporting a gain of 12%, Chrysler 6% and GM trailing with 2%. Behind these figures lie two interesting trends. First, sales of big sports utility vehicles and light trucks continue to lead the parade, despite the recent jump in petrol prices. Second, foreign marques continue to gain market share. Jaguar leads the way, with April sales 98.4% above those in the same month last year. Audi, Nissan and Toyota registered year-on-year gains of 44%, 35% and 16% respectively.

All in all, gross domestic product is growing at an annual rate of about 6%. According to last week's survey of the regional Federal Reserve banks, "increasing input prices ... and worker shortages persisted in

every district (of the country) and practically every industry and occupation". Although the Fed survey reported little evidence that rising input prices and tighter labor markets are driving up consumer prices, other sources indicate that companies' ability to absorb these cost increases is diminishing.

In March the core consumer price index - excluding volatile food and energy costs - posted the largest monthly gain in five years. And a survey by the National Association of Business Economists (NABE)

showed that 94% of the companies responding have been able to make price increases stick, the most in four years. The NABE characterizes this as "a sharp turnaround in pricing power from earlier surveys".

Further evidence that the March rise in consumer prices was not some temporary aberration comes from new productivity and labor- cost information. The improvement in productivity, which had surged at an annual rate of 6.9% in the last quarter of 1999 and was expected to increase at a rate of 3.7% in the first quarter of this year, grew by only a disappointing 2.4%. Unit labor costs, which had declined at an annual rate of 2.9% in the last quarter of last year, rose at a rate of 1.8% in the first three months of 2000.

Still, the inflation doves are urging the Fed to stay its hand. Recent plunges in the Dow Jones and, more especially, in the NASDAQ index, they argue, will cool consumers' ardour to shop until they drop and make many businesses think again about their plans to invest in new plants and technologies.

The central bankers are unlikely to be deterred by these arguments, say Goldman Sachs' economists, who probably represent the consensus view that the drop in share prices will not prevent the Fed from tightening. Share prices and bond yields, reasons the investment bank's Economic Research Group, "still stand at levels which should be consistent with very rapid growth rates in domestic demand and GDP", not only in America but throughout the industrialized world. "Hence, there does not seem sufficient cause for either the Fed or the ECB (European Central Bank) to reconsider their firm intention to tighten monetary policy."

The Fed is encouraged in that hardline view by a bit of arithmetic being put forward by Larry Lindsey, a former Fed governor who is now the principal economic adviser to George W Bush, the Republican presidential candidate. Lindsey says the economy can increase its output of goods and services only to the extent that it increases the workforce and raises the productivity of each worker.

The workforce is increasing at an annual rate of 1% and productivity is rising at an annual rate of 2%. So real GDP can grow only at 3% a year. But with wages growing at 7% a year and Americans "dis-saving" to the tune of another 1% of GDP, demand is growing at 8%. With only 3% more goods coming out of America's factories and service industries, the balance of the 8% demand growth must be reflected in price increases of 5% per year, too high to be tolerated by Greenspan, who sees the Fed as "the ultimate guardian of the purchasing power of our money".

The traditional quarter-point increase will be insufficient to head off inflation of that magnitude - as will an increase of twice as much, to 6.5%. Only a jump, perhaps in stages, to something like 8%, will do the job. The fear that such a rise will turn a soft landing into a jolting crash has made politicians and investors more than a little nervous.