War on inflation continues as economy slows

SUNDAY TIMES (LONDON) June 11, 2000

Everyone seems to agree that the American economy is slowing down enough to make further interest-rate increases unnecessary. So investors who are betting that Alan Greenspan, Fed chairman, and his colleagues will now sheath their anti-inflation sword may be in for a bit of a disappointment.

The evidence that the economy is slowing continues to mount. The number of private-sector jobs fell in May, causing the unemployment rate to rise from 3.9% to 4.1%. New orders for factory goods and for durable goods are down. Sales of new and existing homes fell sharply in April. Manufacturing activity is slowing. Average hourly earnings are not rising and labour costs are increasing only slightly. Nasdaq is no longer creating thousands of millionaires a day.

So the Fed can quit while it is ahead. Its round of six interest-rate increases seems to have piloted the economy onto a glide path to a soft landing. Indeed, were it to tighten further, the soft landing would become a jolting crash. That is the opinion of those who want Greenspan to declare himself the winner in the fight against inflation and take a long summer vacation.

That is not to be. As late as the end of last month Roger Ferguson, the Fed's vice- chairman, said he did not think the inflation risks were "any less great" than before the most recent rate rise. And economists surveyed by the Federal Reserve Bank of Philadelphia last month revised their inflation forecast for this year from 2.5% to 3.1%.

Then came the new indications that the economy is slowing, prompting calls for the Fed to wait and see whether its past increases have slowed the economy to a sustainable growth rate. The Fed does seem to think its increases are "letting a little steam out" of the economy, as Robert McTeer, president of the Federal Reserve Bank of Dallas, told a congressional committee last week.

But McTeer added: "The economy is still strong ..."

His colleague, Jack Guynn, chairman of the Federal Reserve Bank of Atlanta and a member of the monetary policy committee, is even less convinced that the economy has slowed enough to allow the Fed to stand pat.

He told an audience in Atlanta: "Low inflation - while not sufficient by itself - has been the one essential factor in the economy's record performance."

He went on to warn that it would be dangerous to read too much into a one month dip in the unemployment rate. "We will have to wait and see whether or not one month's data is (sic) really indicative of what's happening in labour markets."

Guynn went on to list his worries: high oil prices, rising commodity and import prices, a "creep up" in wages, strong consumer spending and an environment in which "it's much easier for manufacturers to pass on price increases".

Guynn and McTeer are not the only Fed officials who are not persuaded that the fight against inflation can be relaxed. Laurence Meyer, a Fed governor, told the Boston Economics Club last week that it might even be necessary to slow growth to below the long-term sustainable level "for a while" to "contain the risk of higher inflation and to extend the life of this remarkable expansion".

These Fed officials, then, are not impressed by the recent statistics suggesting that the economy is off the boil. For one thing, the Fed has always quite properly resisted reacting to a single month's data. The decline in private-sector jobs in May, for example, must be viewed against the fact that the three-month trend is unchanged.

For another, an economy growing at the 7.3% rate of the fourth quarter of 1999, or even at the 5.4% rate of the first quarter of this year, needs a lot of slowing before it gets to the sustainable rate, now judged to be about 4%.

But most important is the perceived need to correct what Bill Dudley, an economist with Goldman Sachs, calls "significant imbalances in the economy".

Those imbalances are the low savings rate and the high trade deficit.

The low savings rate, of course, has until now been offset by rising share prices, so that consumers could spend all they earned, and then some, and nevertheless become richer. With share prices no longer rising, consumers, already significantly in debt, will have to rein in spending.

If the zipping of wallets is sudden and sharp, a hard landing becomes more likely. Continued gradual tightening by the Fed will cool consumers' ardour for more and bigger houses, new furniture and new and bigger cars – gradually.

The second imbalance is the trade deficit, which is now at record levels and growing. This means that foreigners now hold huge amounts of dollars and American IOUs.

If inflation takes off, or if the economy slows sharply, or if investment in the recovering economies of Europe and Asia becomes relatively more attractive, a sudden sell-off of dollars and dollar assets might occur.

This would drive down the dollar and add fuel to the inflation fires already being stoked by still-tight labour markets.

To correct these imbalances and avoid a hard landing, Dudley is predicting that although the Fed will take no action at its June meeting, it will raise short-term rates from the current level of 6.5% to 7% by late summer, and to 7.5% within the year.

The Fed will do just that if it is convinced another one-point rise in interest rates would slow the economy enough to contain inflation, but not so much as to convert a soft landing into a crash.

Such a further increase would not be good news for home builders, vehicle makers and dealers, durable-goods salesmen and businesses looking to raise equity capital or borrow money - at least, not in the short run.

Longer term, of course, the sacrifice of some above normal growth is a small price to pay for continued, steady long-term expansion.