U.S.: Will The Fed Keep Turning Down The Flame?

Neutral bias or not, it could see the need to act again this year

Is this the end? After the Federal Reserve announced another rate hike on Aug. 24, the financial markets breathed a long sigh of relief. The statement seemed to indicate that the Fed's move might be its last for 1999. But policymakers will remain on the sidelines only if the economy slows down and if labor markets stop tightening further. Those are big ifs.

The Fed hiked the federal funds rate--the rate charged for borrowings between banks--from 5% to 5.25%. It also lifted the discount rate by a quarter point, to 4.75%. Commercial banks quickly echoed the move, raising the prime rate to 8.25%.

The hikes were not a surprise. What snagged the attention of the stock and bond markets was the Fed's statement on its policy bias. A tightening bias would have meant that the central bank's next move would be another hike. Instead, the Fed kept a neutral bias in place. And significantly, the Fed said its actions so far "should markedly diminish the risk of rising inflation going forward." Unlike the more cautious wording of June 30, the day of the last rate hike, this latest announcement strongly suggested that the Fed will not move at its Oct. 5 meeting.

Policymakers may be following one of two tacks. They see a soft landing in the expansion's near future. Or the Fed is willing to gamble that the economy can grow at a sustained pace above 3% without generating inflation. And certainly, the latest data show that the economy began the third quarter at a rapid clip but with little price pressure. In July, consumers were still shopping. Builders were busy. And durable-goods manufacturers saw the biggest jump in new orders so far this year (chart). But at the same time, consumer prices were rising at a benign 2.1% yearly pace.

SO FAR, the Fed's moves have only taken back part of the three quarter-point cuts put in place last autumn to address financial-market turmoil. That means the Fed has room to move quickly if the data hint that, instead of slowing, the economy is actually overheating.

To that end, the Fed will continue to monitor the labor markets and the household sector. Unless consumers downshift their spending, the economy will not slow, and the Fed will have to tap the brakes one more time this year.

Consumers clearly started the third quarter in a buying mood. Retail sales jumped 0.7% in July, led by a large advance in vehicle purchases. But excluding cars, store receipts rose a still-healthy 0.3%. Moreover, the July sales performance has been followed by weekly retail surveys suggesting sales have been solid in August, the traditional back-to-school season.

Many households are feeling extravagant because most consumer fundamentals are flashing the green light. The gain in the stock market so far in 1999 is benefiting nearly half of all households, and rising home prices are boosting the wealth of the two-thirds of Americans who are homeowners. Talk of a tax cut only adds to expectations of more money to spend.

Most importantly, though, the strength in the labor markets is probably the largest contributor to household euphoria. Initial claims for state unemployment benefits were just 287,000 in mid-August, and the four-week moving average was at the lowest in almost 26 years (chart). Fed Chairman Alan Greenspan has frequently mentioned the tightness of the labor markets--and its potential to trigger wage pressures--as a significant concern at the central bank.

HEALTHY JOB PROSPECTS and other helpful consumer fundamentals are also behind the prolonged stellar run of the housing industry. Starts rebounded 5.7% in July, to an annual rate of 1.66 million. And the August Housing Market Index stood at 72%. That's down from July's 74%, but it's still at an historically lofty level.

The rise in homebuilding came even as mortgage rates tipped above the 8% mark for the first time in two years. The rise was the result of a summer sell-off in the bond market as investors worried about the Fed's next move. Now that the bond market is convinced that the Fed will stand pat for a while, the yields on the 10-year and 30-year Treasuries have fallen. Mortgage rates should soon follow.

Keep in mind that housing is one of the fall guys for Fed policy since interest rates control the affordability of home buying. A slowdown in housing activity will be one of the first signs that the Fed's desired soft landing is taking hold.

The Fed's other whipping boy is manufacturing. The factory sector, however, is doing better in 1999 than it did in 1998. Back then, slowing export growth and the General Motors Corp. strike tapped the brakes on output and caused massive layoffs.

Now, those drags have waned, and manufacturing is poised to add to gross domestic product growth again. Total industrial output jumped 0.7% in July, boosted by a heat wave-related surge in utility output. But factory output alone increased a strong 0.6%.

Looking ahead, manufacturing should strengthen further. Durable goods orders increased 3.3% in July, with a 7.3% jump in capital-goods bookings. The orders gain reflects the continued vibrancy in domestic spending as well as the need by many businesses to rebuild inventories, which are at record low levels relative to sales. In addition, export growth is starting to pick up as foreign economies recover.

BETTER EXPORT GROWTH alone, however, won't solve another concern for the Fed: the rising trade deficit. One by-product of the U.S. economy slowing down is that the demand for imports will also fade. That should help to whittle down the massive trade deficit.

Unfortunately, that was not the case in June. Even though exports rose by a small 0.5%, imports jumped 3.9%. Consequently, the trade deficit for all goods and services mushroomed from $21.2 billion to a record $24.6 billion. Over the past year, imports have increased by a huge 13.7%, while exports have managed to rise just 2.1% (chart). Little wonder then that the monthly trade deficit has nearly doubled in a year.

What concerns the Fed is the financing of that soaring trade deficit. At some point, investors will question how the U.S will meet its external obligations. The typical response is for the exchange markets to weaken the value of the debtor nation's currency. A weaker dollar means import prices will rise. And the Fed knows that falling import prices have played a key role in keeping overall U.S. inflation low.

As the Aug. 24 move shows, the Greenspan Fed remains intent on moving preemptively to keep inflationary pressures from gaining a toehold in this economy. So far, it has succeeded. But unless this economy changes from boil to simmer soon, the Fed's work may not be done in 1999.

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