Federal Reserve Chairman Alan Greenspan had a lot to say on July 22, as he usually does when he sits down before Congress to deliver his semiannual testimony on monetary policy and the economy. Much of it was even understandable--especially on Wall Street.
In his familiar, measured drone, Greenspan sounded as if he was not ready to raise interest rates any time soon. He predicted that the economy was likely to continue on a slower growth path in the second half, and suggested that the use of new technology was enhancing the economy's productive capacity, although he said the economy's exceptional performance also reflected temporary factors that have been restraining inflation.
His remarks ignited a powerful bond-market rally that helped to send the Dow Jones industrial average up 155 points. Unlike in earlier speeches, Greenspan did not question the market's exuberance, and seemed less alarmist about inflation concerns than he did earlier this year.
The Fed chief also laid out the central bank's economic forecast (table). The Fed expects economic growth this year to be a full percentage point higher than projected in its February report, and it expects both inflation and unemployment to be a half-point lower. Given the 2% pace of second-quarter economic growth that is generally expected when the Commerce Dept. reports on the quarter's gross domestic product, the Fed's forecast implies that second-half growth will remain in the 2%-to-2.5% range.
THAT IMPLIED FORECAST, relative to what actually happens, could be critical to policy decisions in coming months. Greenspan said that if demand does not increase more slowly than it has in recent years, inflationary imbalances will emerge, and he spoke with particular caution about emerging constraints in the labor markets that could fuel a speedup in wages. With the Fed looking for continued modest growth, evidence of anything significantly stronger than that could easily roil the financial markets.
The possible irony in the market reaction to Greenspan's testimony is that the rallies in bonds and stocks are themselves adding fuel to the economic fire. After his remarks, the benchmark 30-year Treasury bond fell to 6.41%, the lowest in seven months. That means mortgage rates and corporate borrowing costs will fall further. And the stock rally will add even more to households' wealth and sense of well-being.
Commerce's GDP report, due on July 31, will also contain revisions that may be of particular interest to Greenspan & Co. The government's supposedly twin tallies of national income and product have gotten severely out of sync in recent years. So Commerce will try to reconcile the two measures. Most analysts are betting that Commerce will end up splitting the difference: The income side of the accounts will be revised lower, and the product side revised higher.
To the extent that the product data are revised up, official measures of productivity will also be lifted. That's important because Greenspan said the trend in productivity growth is important to the economy's ability to grow at its maximum sustainable rate without generating inflation.
THE SECOND-QUARTER GDP REPORT will fit the Fed's view that the economy cooled off, after a 5.9% growth spurt in the first quarter. Final demand will show only a modest rise, after the first-quarter surge. However, the GDP numbers, combined with recent monthly data, will also offer clues about the economy's strength in the second half. And some of the evidence hints that growth will be faster than what the Fed expects.
One source of stimulus for the economy will come from the government itself. For fiscal 1998, beginning on Oct. 1, Washington plans to trim taxes well before the onerous spending cuts designed to balance the budget by 2002 are put into place. For this fiscal year, the Treasury reported a record surplus of $54.5 billion in June, which means the deficit could total as low as $40 billion. The deficit as a percent of GDP will drop to about 0.5%, the smallest in 23 years (chart).
The coming tax cuts will enhance already healthy household fundamentals. Job and income growth, stock-market gains, and consumer confidence all improved in the second quarter. So, the expected second-quarter gain of just 2% in real consumer spending was most likely a pause before a rebound.
Housing may also pick up in the second half. Housing starts unexpectedly rose 4.8% in June, to an annual rate of 1.45 million. Still, after the winter's mild weather boosted residential construction in the first quarter, homebuilding in the second quarter was probably only up a bit. In the second half, however, solid consumer fundamentals and the summer fall in mortgage rates will lift housing demand further.
BUSINESS SPENDING last quarter did not slow as much as consumer outlays. Indeed, equipment spending is buoyed by the technological changes that Greenspan discussed at considerable length. It appears that equipment purchases last quarter posted a gain similar to the 12% advance in the first quarter, although business investment in structures fell last quarter. Looking ahead, business outlays will be supported by healthy fundamentals: solid demand, strong cash flow, and cheap financing in the equity and bond markets.
One key source of demand for businesses in the second half will be exports. Foreign purchases appear to have surged at a double-digit rate in the second quarter, and improving global economies mean continued strong growth. But imports are accelerating as quickly as exports (chart). The May trade deficit widened to $10.2 billion, from $8.7 billion in April. As a result, net exports were probably a drag on second-quarter GDP. In the second half, because both exports and imports seem set to grow at similar clips, the trade deficit may show only minimal improvement.
Inventories in the second quarter appear to have grown at about the same $50 billion or so amount as they did in the first, reflecting the quarter's continued strength in industrial production. With demand expected to improve, and with auto output already set to increase in the third quarter, inventory accumulation should continue at a high pace in the second half.
Against these forces for growth, Fed policy may be nearing a crossroads. If growth is stronger than the Fed expects, will Greenspan & Co. let the economy run, betting that technology and globalization will forestall inflation in 1998? Or will it tighten policy? Late in Greenspan's speech, he said the Fed is not "involved in an experiment that deliberately prods the economy to see how far and fast it can grow." Even in murky Fedspeak, Greenspan's message was clear: If growth picks up, the Fed is apt to take out more inflation insurance.