Action needed to avoid a hard landing

SUNDAY TIMES (London) May 28, 2000

Rarely has there been a time when the markets and the economists have held such divergent views about the American economic outlook. The markets and those gurus to whom investors look for guidance are guessing that pilot Alan Greenspan and his crew of monetary policymakers will guide the economy from the stratosphere to a soft landing.

"Financial markets are pricing a soft landing for the US economy as the Federal Reserve raises interest rates to slow demand growth and the rise of inflation," writes John Makin, the economist, in his latest market outlook letter.

And why not? Goldman Sachs's much-revered investment strategist, Abby Joseph Cohen, says that the

recent ups and downs of the market are mere bumps on the road to further increases in share prices. According to Cohen, history shows that after every upward move in prices there is a pause while investors digest the new information and price level. Then they take the next step along the upward path to still higher prices.

Cohen and many of her fellow stock-market analysts are expecting corporate earnings to increase by about 10% this year, and share prices as measured by the Standard and Poor's 500 index to rise by about 12% from current levels - which would represent a 7% gain for the year as a whole. In their view, the market has already taken account of - "priced in", to use the jargon of Wall Street and the City - any likely further Fed tightening.

That is what the stock watchers say. Perhaps because theirs is indeed "the dismal science", perhaps because they do not know how to account for investor psychology or perhaps because they have a clearer view of what is going on in "the real economy", economists are not so certain the economy is on a flight path to a soft landing.

Makin titles his latest piece The Need To Fear A Hard Landing and contends that "the data appearing this spring contain the seeds of a hard landing".

That view is repeated, often sotto voce, by economists with whom I spoke at various investment banks.

True, many of Europe's economists are hoping America does have a hard landing, which they see as a sort of comeuppance for all the boasting about the virtues of the great American economic model as compared with the Eurosclerotic one. And some of those in America are Bushies - economists working for the election of George W and whose judgment may be clouded by the fact that an economic upset would deprive Al Gore of one his principal claims to the electorate's favour.

But not all of the qualms felt by many economists can be put down to natural gloominess, American-envy or self-interest. Some start with the proposition that even the talented Greenspan cannot fine-tune the gigantic American economy.

As they see it, he would have to be more than a little lucky if, merely by raising short-term interest rates another half point, to 7%, he can slow the growth rate to something like 3.5% while keeping the inflation rate at about 3%, the dollar steady and share prices at no more than a bit below their current level.

That happy result now seems less likely to economists with whom I have been speaking - admittedly not a scientific random sample - than it did a few weeks ago.

As they see it, the inflation genie is already out of the bottle. Further interest-rate rises will be more than offset by even faster rises in prices, bringing the real cost of borrowing (the interest rate adjusted for inflation) down.

That would encourage consumers and businesses to continue to spend and borrow, fuelling growth to unsustainable levels. In this scenario, continued spending sucks in imports, drives the trade deficit up and the dollar down, adding fuel to the inflationary fires.

Worse still, the recoveries in Europe and Asia are adding to the demand for most commodities, the prices of which have begun to rise, oil being the most prominent example. Indeed, with stocks of many commodities low, and demand rising, further increases in the prices of these raw materials are now widely anticipated by commodity traders.

The problem is compounded by the high indebtedness of American consumers and companies. If the Fed responds to these signs of impending inflation by raising interest rates faster and further, say to 8% in a month or so, it risks placing a big strain on individual and corporate balance sheets, sending share prices into a sharp decline and causing consumers to scurry out of the shopping malls.

So say the growing band of pessimists - who may prove correct, but not certainly so. For one thing, the six recent rate rises ordered by the Fed - a total of 1.75 percentage points - have not yet had time to work their way through the economy. Indeed, these increases have been more than offset by a 2 percentage-point hike in prices, so that consumer borrowing costs have not risen in real terms. This means that the Fed has not yet really unsheathed its interest-rate weapon and has lots of room to dampen demand if it is of a mind to do so. In short, so far it has done too little to stop inflation taking hold.

Even gloomy Makin thinks that a further rapid increase in interest rates by the Fed might enable the economy to avoid a hard landing. But he adds: "That increase needs to come quite quickly, at a pace that is uncharacteristic of this tightening phase to date by the Greenspan Fed."

As ever, the ball is in Greenspan's court. Washington observers say that even at his age the tennis-playing Fed chairman moves around the tennis court with agility and style. They are hoping those skills are equally on display when he gets to his office.