AN OUNCE OF PREVENTION MAY BE WORTH A POUND OF CURE
Federal Reserve Board Chairman Alan Greenspan wants to vaccinate the economy against inflation. In his Jan. 31 testimony on Capitol Hill, Greenspan suggested that the Fed is seriously considering raising interest rates in an effort to thwart any new inflationary pressures. His argument: A shot now could avoid the need for stronger medicine later.
To be sure, inflation is nowhere in sight. But unlike the strategies of past Fed chiefs, Greenspan's foe right now is not inflation. His battle is with inflation expectations, which are hard to remove after they become ingrained into economic thinking. Because these expectations are an important component of long-term interest rates, efforts to reduce them will also keep long rates down. So in a perverse sense, higher short-term rates now will help to prolong the business expansion.
It's a compelling argument. Long rates plunged in 1993, mainly because deficit reduction eased the bond market's long-held fears that big deficits would fuel inflation. As Greenspan pointed out, significant inflation expectations are still embodied in bond yields, meaning that rates are higher than current inflation can justify. So more progress on reducing expectations will allow long rates to decline further.
The contribution of lower long-term rates to economic growth was dramatic in the report on fourth-quarter gross domestic product. Real GDP grew at a sizzling 5.9% annual rate at the end of 1993, while fourth-quarter inflation, measured by the GDP fixed-weight price index, rose at a tame 2.2% annual rate.
Growth was powered by gains in the rate-sensitive sectors, including housing, business investment--especially in equipment--and consumer spending for durable goods (chart). During the past year, those three sectors have accounted for 93% of the economy's growth.
The Fed's policy committee meets on Feb. 3-4 to determine the appropriate time to begin tightening up. An outright rate hike before Greenspan's Humphrey-Hawkins testimony on Feb. 22, when the chairman defends the conduct of monetary policy before Congress, could be politically tricky, but given the tone of Greenspan's remarks, it cannot be ruled out. One good bet is that the Fed will at least officially slant policy toward tightening.
When the Fed does act, the most expected move is a quarter-point hike, to 3 1/4%, in the federal-funds rate, the Fed-controlled anchor for short rates. But several Fed watchers do not rule out the possibility of a half-point hike, combined with a half-point boost in the discount rate, to 3 1/2%. The discount rate is largely symbolic, but highly visible as a policy barometer. Such a move would have a big impact on inflationary expectations by strongly signaling the Fed's vigilance against inflation.
The timing of a rate hike is further clouded by the unexpected resignation on Feb. 1 of Fed Vice-Chairman David W. Mullins Jr., who will not attend the policy meeting. Ditto Governor Wayne D. Angell, whose term is up. The bond market viewed both as inflation-conscious, and it sold off sharply on Mullins' announcement, fearing that President Clinton's yet-to-be nominated appointees would be less inclined to worry about inflation (page 29).
Undoubtedly, the economy's strength, combined with the Fed's accommodative policy of the past 1 1/2 years, will factor into the central bank's deliberations. The federal-funds rate, after adjusting for inflation, is "abnormally low," in Greenspan's words. He said this policy was a deliberate attempt to allow businesses and consumers to repair their highly leveraged balance sheets.
But now, that process is well advanced. The progress is especially evident in the new aggressiveness in bank lending. Since April, 1993, bank loans have exploded, growing at a 6% annual rate, after no growth in the previous two years.
Moreover, much of the economy's fourth-quarter momentum is carrying into 1994. In December, construction outlays surged, while new-home sales soared to an eight-year high (chart). Durable-goods orders rose 2.2%, as capital-goods shipments jumped. And personal income posted another healthy gain. All this suggests further increases in housing, equipment investment, and consumer spending.
Continued strength was also the message from the index of leading indicators, which rose 0.7% in December, the fifth straight monthly advance. Eight of the 11 indicators contributed to the gain, led by rising consumer expectations, a pickup in the growth of materials prices, and fewer new jobless claims.
The manufacturing sector remained lively in January, according to the National Association of Purchasing Management. The NAPM's index of industrial activity rose to 57.7% last month, up from 57.1% in December, and new orders kept coming in. The orders index jumped to the highest level in 10 years (chart). The purchasers also reported a considerable increase in industrial prices, but it remains to be seen if those hikes will stick.
If successful, Greenspan's long-rate therapy will be especially helpful in two crucial areas: consumers and construction. Consumer spending on durable goods soared at a 14.4% annual rate last quarter. The housing boom boosted demand for appliances and furniture, and low rates made financing big-ticket items attractive.
More important, personal income was on a roll last quarter. After adjusting for prices and taxes, real income rose at a 5.2% annual rate (chart). Since that outpaced the total spending gain of 4%, consumers began 1994 with some extra cash.
The consumer data may look weaker in January if the Arctic blast and earthquake shortened work hours, cutting into paychecks. And many consumers shifted their spending from buying appliances to turning up the thermostat. Still, even if spending fell last month, it ended 1993 at such a high level that the January number should be well above the fourth-quarter average.
Of course, many households will feel an impact from a Fed tightening. Homeowners with adjustable-rate mort-gages may see their rates rise for the first time in five years. However, interest income--a casualty of the Fed's past rate cuts--may pick up. And continued low long rates will enable more people to buy homes.
Home sales were very strong in December, especially in the Midwest. New single-family homes sold at an 862,000 annual rate, 11.4% above the November level. That surge left builders with fewer homes to show. At the December sales rate, the inventory of unsold houses slipped to a 4.5 months' supply, the lowest since July, 1971.
House-hunters were out in January as well, reports the National Association of Home Builders. Despite the weather, buyer traffic was good last month, and sales of single-family homes kept pace with their robust fourth-quarter level. Increased home buying means another good year for residential construction, which surged at a 31.7% clip in the fourth quarter.
Other construction sectors are also showing more muscle. Spending on all types of buildings has risen for eight straight months, including an unexpectedly strong 2.6% advance in December. Commercial real estate is finally coming back. Spending on nonresidential buildings has increased for five consecutive months and now stands 17.5% above its year-ago level. And rebuilding from the earthquake as well as ice-related road repairs will lift spending on government projects.
Clearly, the economy's broad strength has not gone unnoticed by the Fed. And given the new momentum, Dr. Greenspan is on the lookout for the classic symptoms of inflation, such as tight labor markets and shortages of production capacity. That's why he would prefer to practice a little preventive medicine now, rather than whip out a big spoonful of castor oil later on.JAMES C. COOPER AND KATHLEEN MADIGAN