Will The Bond Market And The Fed Desert Clinton?by
President Clinton strode into 1993 with big economic plans and two key allies: falling long-term interest rates and a friendly Federal Reserve. Now, the bond market, thoroughly disillusioned, has pushed long rates back up. And the Fed appears to be holding a cocked pistol, ready to fire off a hike in short-term rates at the slightest provocation from the price indexes.
It's a combination guaranteed to make the White House shudder. The Administration needs low interest rates to offset the fiscal drag from its proposed deficit reduction. Otherwise, it risks a sour economy--or even recession--in 1994, when the raft of new taxes needed to pay for its economic program starts to kick in.
Little wonder then that consumers continue to lose faith in the future (chart). That probably reflects the fear that higher taxes will rob income in an unsettled job climate. And the uncertainty over the future of the Administration's budget proposals has put business in a bind. For example, durable-goods orders were flat in April, suggesting some hesitancy at ordering big-ticket items, although retailers' efforts to work down inventories is also holding back factory demand.
The situation, however, is not as bad as it looks. Households may say they are downbeat, but sales of cars and homes are holding up. The bond market's worries about inflation are exaggerated, as are its fears that Clinton's budget package is about to explode. And finally, it seems highly unlikely that the Fed is about to embark on a major campaign to tighten monetary policy.
To be sure, the Fed cannot ignore recent signs of faster inflation, if only to maintain its credibility in the financial markets. Indeed, following a recent report in the business press, speculation is rife that the Fed shifted its policy predisposition at its May 18 meeting to one of tightening from that of steady-as-she-goes.
The central bank has not issued such a directive in four years. It usually gives Fed Chairman Alan Greenspan the authority to hike the federal funds rate by as much as half a percentage point, if warranted. But the economic fundamentals argue overwhelmingly that the recently unruly price indexes will settle down.
Nevertheless, all eyes will be on the May consumer price index, due out on June 15. A gain of 0.2%--a 2.4% annual rate--or less would clearly mean no tightening. But a rise of 0.4%--a 4.9% annual rate--would cause the Fed to pull the trigger. A 0.3% increase is the tricky call. Regardless of the number, the breakout between the total and the core indexes will sway any policy decision.
One thing that will not influence Fed policy is the recent surge in the money supply. The broad M2 measure jumped by $20.1 billion in the week ended May 10, after a $13.2 billion surge. The two-week gain was the second-largest on record.
The ups and downs in M2 have more to do with this year's anomalies in the flow of tax payments and refunds than with fundamental factors. Despite the surge, M2 remains below the Fed's growth targets (chart), as people shift funds out of small-time deposits, which are part of M2, and into stock and bond funds, which are not. Because of these distortions, the Fed says that it largely ignores M2's gyrations in the formulation of policy.
As for long-term interest rates, the bond market is worried that inflation is about to flare up and that Clinton's lack of political savvy will kill chances for deficit reduction. The rate on 30-year Treasury bonds now stands at about 7%, up from a low of 6.73% four weeks earlier. By the Administration's own measure, that robs the economy of almost $30 billion worth of stimulus.
New White House efforts at compromise, however, especially with members of its own party, are increasing the chances for a deficit-reduction package. Moreover, the eventual budget mix could be slanted more toward spending cuts and less toward tax hikes--more to the bond market's liking. A final budget plan will remove the uncertainty now plaguing business, and it will shore up households' flagging faith in the future.
Indeed, the month of May was anything but merry for consumers. The Conference Board's index of consumer confidence slid more than six points, to 61.5. The big tumble came in expectations for the future, which fell to 72.2 from April's 81.1. The prospect of paying more taxes--whether to fund deficit reduction or health care--is cutting into expected income growth.
Confidence has been sliding since December, but this may reflect declining trust in Clinton rather than in the economy. Indeed, sales of U.S.-made cars rose to an annual rate of 7.4 million in mid-May, the highest 10-day pace this year. The housing market also remains on solid ground. Sales of existing homes increased by 2.7% in April, to an annual rate of 3.46 million.
Certainly, jobs remain uppermost in the minds of consumers. The lackluster April employment report, released in early May, probably heightened worries about the economy's footing. The Conference Board reported that only 13% of those asked in May think there will be more jobs by yearend. That's the lowest reading on future hiring in more than a year.
But even here, perceptions may be worse than reality. A survey by Manpower Inc. suggests that hiring will pick up in the third quarter, although job growth in the West remains weak. And a Dun & Bradstreet Corp. survey of 5,000 businesses projects a gain of 2 million jobs this year, with most coming in the second half.
D&B says, however, that corporations with more than 25,000 workers plan, on average, to cut payrolls. Since layoff announcements by large companies generate headlines, the notion that hiring is weak may persist into next year, even as small concerns expand their payrolls.
Businesses may be reluctant to hire because the uncertainty of Washington policy makes the future so vague. That incertitude is probably hampering other decisions as well. Demand for big-ticket items is suffering. Durable-goods orders were unchanged in April, after a 3.4% decline in March. As a result, unfilled orders fell by 0.6%, to their lowest level in 41 2 years (chart).
New orders had soared in December, as corporations anticipated Clinton's proposed investment tax credit, now all but dead. Once burned, these companies will likely wait for the final budget details before ordering more capital goods. When the budget squabble is finished, perhaps by August, the drag on the economy will ease.
Ironically, Washington's attention to deficits in future years masks the improvement in fiscal 1993 finances. Through April, the 1993 deficit is running $10 billion below its total for the first seven months of 1992.
Rising tax receipts and a slowdown in outlays are stanching the red ink. Receipts in the first seven months are up by 4.4% from a year ago. Corporate tax payments have ballooned by 16.2%, thanks to the rebound in business profits. Outlays, meanwhile, are up just 2.1% from 1992. Low rates have cut interest payments by 1.6% this year, and defense spending has also declined.
Unfortunately, though, the improvement won't continue. Congress' refusal to fund the Resolution Trust Corp. has reduced outlays by $12.5 billion since October. Now, Congress is moving to approve more money for the thrift bailout. Those extra funds mean the 1993 deficit could very well total a shade over $300 billion. While that figure will still eclipse last year's record of $292.2 billion (chart), it will come in less than the White House's projection of a $310 billion shortfall.
So far, the Clinton Administration's Keystone-Kop approach to economic policy has alienated the financial markets and the voters who elected him. But Clinton's touchy-feely, conciliatory brand of politics may yet work, shoring up support for the President. And as long as inflation slows down again, the Fed will remain one of the most important Friends of Bill in Washington.