Riding The New Economy

The ticklish task for Greenspan, Summers, and other policymakers: how to rein in this buckin' bronco without stopping it dead

If ever there was a time when policymaking was simple for the Federal Reserve, this is surely not it. Faced with a supercharged economy, sky-high stock markets, tight labor conditions, and incipient fears of inflation, Fed Chairman Alan Greenspan has tried since last June to rein in the galloping U.S. economy.

But a funny thing happened on the way to the slowdown. Not only is the economy refusing to cool, it's actually charging ahead. And to further muddy the picture, the astonishingly strong productivity numbers reported by the Labor Dept. on Feb. 8 have emboldened critics who say the Fed should not continue to raise rates. For now, there's precious little evidence of inflation in sight.

Call it the revenge of the New Economy. Things are so good these days that policymakers, such as Greenspan and Treasury Secretary Lawrence H. Summers, face a new set of challenges posed by prosperity itself. Not the least is that the high-flying stock market has somewhat weakened the Fed's ability to influence the economy through the traditional lever of interest rates. And that is making the Fed's already tough job of striking a balance between growth and inflation even tougher.

For now, the economy and the markets are continuing to barrel ahead. The economy added 387,000 jobs in January, sending the unemployment rate to 4.0%, its lowest rate in 30 years. The gross domestic product grew at an annual rate of 5.7% in the third quarter of 1999 and 5.8% in the fourth quarter, well above what's generally considered a sustainable pace. Meanwhile, the Nasdaq Composite Index has nearly tripled in the past 18 months. Consumers, sitting on big capital gains, are borrowing and spending with nary a thought of tomorrow.

TROUBLE TRIGGER? In more ordinary times, the primary thing that policymakers worry about when growth is rapid is that bottlenecks in the supply of labor, raw materials, and other inputs will cause inflation to rear up. That's still a big concern. But today, Fed insiders are equally worried that the stock market--revved up by the successes of the New Economy--could be the trigger for trouble. If sentiments suddenly shift, a stock market crash could tip the economy into recession. And if the Fed manages to stave off that fate by flooding the economy with money, it could ignite the very inflation it has been working so hard to avoid. Scary.

Even plainly good news, such as soaring productivity growth, presents perplexing questions. On Feb. 8, the Labor Dept. announced that output per hour of work had grown at an annual rate of 5% in the fourth quarter--an increase in efficiency so large that unit labor costs actually fell at an annual rate of 1%. Great, right? Yes, but it points to the dilemma facing the Fed: How can it publicly justify raising interest rates when inflation doesn't appear to be breaking out?

Good times, it seems, can be as tricky to manage as bad times. In order to know how to manage the economy, it's important to know why it's growing so rapidly in the first place. Some of the GDP strength was temporary, including a surprise yearend jump in defense spending and precautionary inventory-building by companies worried about supply disruptions from the Y2K computer bug. But much of the oomph came from consumers who had seen their stock portfolios swell. Greenspan reckons that higher stock prices have boosted growth by a full percentage point each year since late 1996 by encouraging consumers to spend more and companies to increase investment with funds raised on Wall Street.

In an effort to slow down the economy, the Fed has lifted interest rates by a quarter-point four times in the last seven months and is poised to increase them further in the months ahead, starting with its next policymaking meeting on Mar. 21. But so far, the effect on the economy has been limited. The housing market has shown signs of plateauing in response to higher mortgage rates, but it is not declining. The auto market--another interest-rate-sensitive sector--racked up its strongest sales in five months in January.

Why haven't the hikes had more of an effect? For starters, they've been modest. Three of the Fed's four rate hikes just made up for the hurried cuts it made in 1998 to avoid a global financial meltdown. In addition, consumers feel free to borrow and spend, even if it costs them a bit more to do so. The Fed said Feb. 7 that consumer credit surged 7.6% in 1999, the biggest gain in three years. "Americans continue to feel wealthy," says Richard B. Berner, chief economist at Morgan Stanley Dean Witter.

Nor are companies feeling much of a pinch, in part because of the profit payoff from the productivity boom. Lowell Gordon, controller of Electronic Environments Corp., a Canton (Mass.) electrical construction and service business, believes his customers have shrugged off the rise in rates so far. That's even truer in Silicon Valley, where fewer companies rely on bank loans. "We get our cash from the equity markets," says Randall Bolten, chief financial officer of BroadVision Inc., a fast-growing Redwood City (Calif.)-based maker of software used to set up e-commerce sites.

Across the economy, banks today play a smaller role in credit creation than ever before. Their share of total net credit market lending has fallen from 63% in the 1970s to around 32%, according to an analysis of Federal Reserve data by RFA Dismal Sciences, a West Chester (Pa.) economic consulting firm. That means the Fed's lever over the economy--through interbank lending rates--has lost some effectiveness.

JUICED-UP ECONOMY. Meanwhile, gains in the stock market continue to juice up the economy--and the Fed has little direct influence over stock prices. While the Dow Jones industrial average and Standard & Poor's 500-stock index have slowed their climb, the Nasdaq has soared by 64% since the Fed started to tighten.

One way higher rates usually quell inflation is by strengthening the dollar, making imports cheaper. But even that mechanism is weakening as currency traders focus on equity flows more than rates.

Why doesn't the Fed act to raise rates more sharply? It's worried that making such a bold move would trigger a stock market crash that would throw the economy into a recession. "It's trying to feel its way to the right stance in monetary policy," says Columbia University economist Frederic Mishkin, a former New York Fed research director.

As important as knowing what to worry about is knowing what not to worry about. One thing to take off the worry list is the widely discussed notion that the retirement of the federal debt undermines the Fed's ability to set monetary policy. It's true that the yield on the 30-year bond recently fell as low as 6.13% because of concerns about scarcity, at the same time the Fed was trying to push up short-term rates. But Fed officials note that the fall in Treasury yields was not matched by a decline in mortgage rates or corporate bond yields, which matter more to the real economy. "Treasuries have been in a world of their own," says veteran Fed watcher Louis B. Crandall of consultants R.H. Wrightson & Co.

The problems of prosperity are the kind that other countries would love to have. But that doesn't make them any easier to solve. They're more difficult--because they've never been faced before.