The Word From The Fed: The Recovery Keeps Wheezing Along

When Federal Reserve Board Chairman Alan Greenspan gave his semiannual testimony on July 21 and 22 on the conduct of monetary policy, the congressional committees hurled some pretty tough questions at him. As usual, Greenspan had plenty of answers--some of which were even understandable.

Why is the recovery so anemic, asked the lawmakers? Greenspan said the economy's structural imbalances were more severe and more enduring than previously thought, but that growth will soon gain momentum. Why is the unemployment rate so far above the Fed's forecast of only six months ago? Answer: The growth of the labor force surged well above the pace suggested by the growth of the working-age population, so both labor force growth and the jobless rate should retreat in coming months.

On the testy subject of money growth: Why has the growth of the M2 measure fallen out of bed? Greenspan blames "disintermediation," the shifting of funds from small-time deposits at banks to higher-yielding investments that are not a part of M2. But isn't slow money growth still a problem for the recovery? Not really. He says that the velocity--or turnover rate--of money is rising, and that money doesn't have to grow as fast.


Greenspan had an answer for everything. Still, his cool and informed responses did not allay the nagging worry that monetary policy has been unable to address the fundamental underperformance of economic growth. Despite the "23 separate easing steps, beginning more than three years ago" that the chairman referred to, economic anemia seems entrenched.

The Commerce Dept.'s report on second-quarter gross domestic product, to be released on July 30, will make that point clear. BUSINESS WEEK estimates that real GDP grew about 1.5% last quarter. That pace would be far below the first quarter's gain of 2.7% and not at all reassuring that a sustainable recovery is under way.

Last quarter's real GDP suffered from a sharp widening in the trade deficit that offset perhaps all of the positive contribution from a pickup in inventory growth. Elsewhere, growth in domestic demand was weak, mainly reflecting puny growth in consumer spending.

Greenspan tried to soothe concerns that the recovery might be petering out. His succor was in the context of the Fed's latest economic forecast (table). The central bank projects that real GDP will grow in the range of 2.25% to 2.75% in 1992, measured from fourth quarter to fourth quarter, and 2.75% to 3% in 1993. Based on second-quarter growth of 1.5%, the Fed's 1992 forecast implies a second-half pickup in growth to 2.5% to 3.5%.

As expected, Greenspan addressed the notion that money growth was too slow to be consistent with the Fed's projections for economic growth. Through early July, the broad M2 measure of money was growing far below the lower bound of the Fed's target range of 2.5% to 6.5%. In fact, for M2 to get back to the midpoint of its target, it would have to grow at an annual rate of 7.5% from now until the end of the year, a pace that hasn't been achieved in nearly three years.

Not to worry, says the chairman. Money is changing hands more rapidly. The velocity of M2 rose appreciably last quarter (chart), and it now stands well above its average level since 1980. Higher velocity is implicit in the Fed's forecast, and Greenspan says that the trend may continue. If so, it will take less money growth to support a given pace of nominal GDP growth--that is, growth not adjusted for inflation.

However, the velocity explanation can only go so far. If money growth continues to be so feeble, especially in the face of weak economic growth, further Fed easing later this year cannot be ruled out.


Greenspan's cautious optimism may not have played well on Capitol Hill, but in his defense, the improving outlook for housing is consistent with a moderately upbeat view of the economy. The plunge in mortgage rates, touched off by the Fed's July 2 cuts in interest rates, will do much to revive this important sector.

Homebuilding ended the second quarter on a sour note. Housing starts fell by 3.2% in June to an annual rate of 1.17 million. Construction of single-family homes dropped 2.4%, while apartment projects, still in a tailspin caused by past overbuilding, dropped 21.4%.

However, homebuilding should get a boost from cheaper mortgages. The average rate on a 30-year fixed mortgage in mid-July dropped to 8.22%--the lowest in 19 years. One-year adjustable rates, at 5.36%, are at the lowest since they came into existence a decade ago.

Little wonder, then, that mortgage lenders were burning the midnight oil last month. According to the Mortgage Bankers Assn., loan applications for home purchases surged 30.8% in the two weeks ended July 10.

The MBA's index of applications for home purchases is now at its highest since January, when the Fed's big easing move in December also caused a surge in home buying (chart). Because it takes about 60 days for a mortgage to be approved, this rise in mortgage applications will likely cause an increase in the government's data on home sales in August and September.

The MBA also reports that applications to refinance existing mortgages have soared back to their Olympian heights of January. Lower monthly mortgage payments will free up money for homeowners, and this extra cash will lift consumer spending in the third quarter.

Long-term rates may head even lower. Greenspan lamented that long rates remained "disturbingly high," blaming inflation fears generated by federal budget deficits projected into the mid-1990s. Some relief may be on the way, though.

Based on data through June, when the Treasury posted a small surplus of $3.8 billion, the deficit for fiscal 1992 now seems likely to end up in the range of $300 billion to $315 billion, far below the feared $400 billion mark. A slower pace of spending by Resolution Trust Corp. for the thrift-industry bailout is the reason for the lower 1992 deficit, although red ink will run heavier in 1993 as RTC spending picks up again.

For now, though, the smaller 1992 deficit means that the Treasury's third-quarter borrowing will be about $90 billion--only half of the IOUs implied by a $400 billion deficit. The combination of less Treasury borrowing, a slow recovery, and low inflation could produce lower long-term rates this summer. That would give housing an additional lift and provide further help for debt-strapped households to repair their balance sheets.


Greenspan made little mention of foreign trade in his testimony--perhaps because it is turning out to be such a dark cloud over the outlook. Slower growth in other countries is hampering U.S. exports, while the recovery at home is increasing demand for imports.

As a result, the merchandise trade gap is deteriorating. In May, the deficit widened to $7.4 billion, from $7.1 billion in April. Exports dropped for the third consecutive month, falling 2.5% to $35.5 billion. Imports also fell, but by a smaller 1.4%, after rising in March and April. During the past year, imports are up 7.2%, compared with last May, when they were falling 1.5%.

The wider trade gap suggests that foreign trade was a huge drag on the economy last quarter. After adjusting for price changes, the GDP measure of foreign trade--net exports--will likely show a doubling in the deficit in the second quarter (chart). That deterioration would subtract almost two percentage points from the quarter's annual rate of growth.

Sagging foreign trade is only one of the problems facing the recovery. If you take Chairman Greenspan at his word, none of the existing troubles is too overwhelming for the economy to handle. But Greenspan would undoubtedly admit that the task of mollifying Congress is a lot easier than keeping the recovery on track.

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