General Greenspan Trains His Guns On Inflation

Monetarist Milton Friedman and Keynesian Paul A. Samuelson are ideologically opposite economists with at least one common belief: Both think U.S. monetary policy is too tight. Federal Reserve Board Chairman Alan Greenspan's blunt response: "I do think they are both wrong."

And so it went during Greenspan's semiannual trip to Capitol Hill on July 20 to defend the Fed's conduct of monetary policy. For someone whose job it is to mince words at these affairs, the chairman was unusually clear. His message: The economy is out of danger, the Fed's top priority is inflation control, and the next policy move is tightening--it's just a matter of time.

The Fed chief said the economy, while not especially bubbly, is "clearly not about to tilt over into a significant state of weakness or contraction." On inflation, Greenspan sounded downright hawkish. He said the news on inflation this year could only be characterized as "disappointing," the disinflation process seems to have "stalled," and inflation expectations appear to have "tilted upward."

Greenspan's tough talk took the credit markets by surprise. Short- and intermediate-term interest rates jumped as any lingering expectations of another Fed rate cut vanished. Long-term rates ended up little changed, as the bond market seemed reassured that the central bank will not tolerate higher inflation.

In another unexpected twist, the Fed chairman offered real interest rates--market rates minus inflation--as a long-term guide for Fed policy. Under that new paradigm, current policy would have to be characterized as loose and potentially inflationary. That's because the real federal funds rate, now near zero, is very low compared with its historical average of about 2%.

That's a sharp reversal from the low-inflation signals given by the Fed's previous policy guide, which relied on the growth rate of the M2 money supply. Greenspan said that the Fed has all but dropped M2 as an indicator of financial conditions because it is no longer reliable.

The Fed chairman was not at all sympathetic to the concerns generated by the latest round of soft economic data. Housing starts were flat in June despite mortgage rates at a 25-year low (chart). June industrial production fell for the second consecutive month. And in July, the University of Michigan's index of consumer sentiment wilted to a nine-month low. Economic growth had already faded to 0.7% in the first quarter, with growing concerns about the second quarter as well.

Not to worry, says Greenspan. In an unusually bold forecast for a Fed chairman, he said that second-quarter real gross domestic product--to be released on July 29--was clearly in excess of 2.5%.

Moreover, a quickening of growth in the second half is implicit in the central bank's latest economic projections for 1993 and 1994 (table). For '93, the Fed forecasts growth of 21 4% to 23 4%. If Greenspan is right about the second quarter, that means the central bank expects second-half growth in the neighborhood of 3.5%.

Despite the weak-looking data of late, the Fed's forecast may well be on the mark. Second-quarter GDP should show a healthy mix of growth in final demand and a slower pace of inventory growth. That's just the opposite of what occurred in the first quarter, and that combination sets the stage for a better performance of industrial output in the second half.

Even though confidence is flagging, consumer spending appears to have grown at an annual rate of about 3% in the second quarter. If second-half job growth at least matches the 1 million jobs created in the first half, consumers seem able to maintain that pace.

Also, business investment in equipment should continue to bolster growth because of low interest rates and solid profits. The trade deficit isn't likely to widen as much as it did in the first half. And while the full impact of lower mortgage rates has not yet shown up, it will. Mortgage applications to buy a home are on the rise.

For now, housing and industrial production look pretty anemic. Housing starts in June held at their May annual rate of 1.25 million, while single-family starts dipped by 2.8%, to 1.08 million.

The lack of strength, though, partly reflects the heavy rains that began in mid-June in the Midwest and in areas of the South. Starts in both regions fell in June, while new home construction in the Northeast and West posted solid gains. The hit should be even harder in July, when the full brunt of the flooding shows up in the data.

A rebound in the housing market would bring a welcome boost to demand for home-related goods. Because of the weather-related buildup in retail inventories over the winter, orders for consumer items have suffered, putting the brakes on production. Over the 12 months ended in June, output of consumer goods has edged up 3%, compared to the stronger 10.7% gain in the production of business equipment, mostly computers (chart).

Overall, industrial activity was lackluster in the second quarter. Output fell 0.2% in June, after a 0.1% dip in May. Total operating rates stood at 81.2% in June, down from 81.5% in May. For the quarter, output grew at a 1.8% annual rate--less than a third of its 5.6% advance in the first quarter.

Manufacturing will enjoy a stronger third quarter, though. True, July will be a wash because the Mississippi flooding halted most cross-country cargo and closed some factories. But auto production is expected to increase this quarter. And retailers continue to draw down their inventories, setting the stage for more ordering later on.

Business inventories rose 0.2% in May, but store stockpiles were unchanged. Thanks to sales gains in April and May, retailers have wheedled down their inventory-sales ratio from a bloated 1.61 in March to 1.58 in May.

But other drags in the industrial sector point out the challenges the Fed faces in keeping this economy on track. Simply put, structural problems can't be solved by monetary policy. Low interest rates will hardly help to curtail defense cuts, and an anti-inflation stance can't correct the global recessions now holding back U.S. exports.

Looking overseas, the central bank is likely anticipating that growth in the other industrialized countries will pick up by next year. Stronger growth overseas would lessen the risk that the Fed will be raising rates next year, while other countries are cutting them. In addition, a global turnaround could help reverse the deterioration in the U.S. trade picture.

The U.S. merchandise trade deficit, which had widened greatly from last December through April, narrowed in May. The gap shrank to $8.4 billion from $10.2 billion in April as exports rose 1.2% and imports fell by 2.8%. The shrinkage means that trade will not be as big a drag on growth in the second quarter as it was in the first, when a wider deficit alone sapped 1.7 percentage points from real GDP growth (chart).

Almost all the May improvement was in trade with Japan. The U.S. deficit with Japan fell to $3.8 billion from $5.5 billion in April. However, Japan has already reported a wider trade surplus with the U.S. for June. That means any trade improvement for that month will have to come from other economies, in particular the developing nations of Latin America and the Pacific Rim. U.S. exports to these countries continue to grow faster than shipments to Japan and Europe.

Until the rest of the industrialized world gets back on its feet, U.S. producers will have to look homeward for growth in demand. If Greenspan is right, domestic demand will be sufficient to carry the economy into 1994. But given the Fed's renewed aggressiveness toward inflation, the U.S. had better hope Europe and Japan get their economies moving again soon, because the Fed intends to keep demand here at home on a short leash.

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