Dollar Doldrums Alone Won't Force The Fed To Tighten

There's an old rule in currency intervention: Don't try to row upstream. On June 24, the Federal Reserve and 16 other central banks spent more than $3 billion trying to prop up the U.S. dollar against market forces determined to send it the other way. As usual, the market won.

Coming off this failed effort amid stubborn dollar weakness and its depressing influence on U.S. bond and stock markets, the Fed's policy-making committee will sit down July 5-6 to plot monetary strategy. The popular question: Will the Fed have to raise interest rates in order to shore up both the greenback and sagging investor confidence in U.S. securities?

If the trends in the data are any indication, such a move seems unlikely--if not foolhardy. The numbers continue to show that economic growth is already slowing down, a point that was clear in the central bank's own regional survey prepared for its upcoming meeting. In addition, inflation prospects remain reassuring, as Fed Chairman Alan Greenspan himself noted in his congressional testimony on June 22.

The latest evidence of these trends: Sales of existing homes dipped in May, and while purchases of new homes rose that month, sales seem to have peaked. Consumers still feel confident (chart), but rising rates and low savings will temper the boom in durable-goods purchases. Indeed, factory orders for such goods posted a tepid gain in May, leaving bookings no higher than they were in January.

At the same time, inflation news has improved. Oil prices are down about $1 per barrel since mid-June, and commodity prices have retreated from their recent highs, despite surging coffee prices caused by frost in Brazil.

Besides, where interest-rate policy is concerned, the Fed just doesn't place that much importance on the dollar. It never has. The central bank has always given top priority to domestic issues such as growth and inflation. If the Fed judges that inflation control does not require higher rates, then it will not act solely to buoy the U.S. currency.

Such a bold cure could even cause more harm than good by admitting that a disease exists. In fact, economic fundamentals in the U.S. right now should be more supportive of the greenback. The dollar's weakness has been narrow, focused mainly against the Japanese yen and the German mark. Even there, the decline has been orderly.

Moreover, the dollar-yen relationship looks increasingly more like a problem for Japan than for the U.S. The strong yen presents tough problems for Japanese exporters, and on June 29, the yen hit a new high after the selection of a Socialist Prime Minister, Tomiichi Murayama. The vote decreases the chance for deregulation and economic stimulus needed to reduce Japan's huge trade surplus, the major reason for the yen's strength.

Against this backdrop, the Fed seems most likely to put off any rate hike until its August meeting, if then. The policymakers are still monitoring the impact of the large half-point hike on May 22, along with that of previous increases. Another rate boost in the face of moderating growth and tame inflation would risk looking like overkill, only feeding growing tensions between the Fed and the White House.

Although the effect of past Fed tightening, which began on Feb. 4, is only now beginning to show up in the economy, the impact is clear enough from the monetary data. In particular, bank reserves--the basis for money creation--have fallen at an annual rate of 7.2% since early March. Not surprisingly, the narrow M1 money supply has flattened out since early April, after growing at a 7% annual clip during the previous six months.

Moreover, growth in the broader M2 measure of money has fallen back to the bottom of the Fed's 1% to 5% target range. That's significant, since you can no longer blame huge shifts of funds out of M2 and into mutual funds for that slowdown. Flows into stock and bond funds have fallen off sharply this year. The weaker money numbers strongly suggest that Fed tightening has already set up monetary conditions that often foreshadow slower economic growth.

The No.1 casualty of the Fed's tightening is housing. Clearly, home buying and building are in no danger of a slump, but housing's biggest contributions to this expansion are history (chart). Sales of new single-family homes rose 4.2% in May to an annual rate of 738,000, but the second-quarter tally is well below the pace in 1993's fourth quarter. The same is true for sales of existing homes, which fell 0.7% in May to a 4.09-million annual rate.

That fourth-quarter peak is unlikely to be regained now that 30-year fixed mortgage rates are averaging 8.65% for the week ending June 24. The Mortgage Bankers Assn.'s tally of mortgage applications for home purchases is down sharply. In mid-June, it hit a 11/2-year low.

Still, housing has its supports. The Fed's interest-rate hikes since February appear to have had no appreciable impact on consumers' spirits, which have been buoyed by better job growth. The Conference Board's index of consumer confidence rose to 92 in June, up from 88.9 in May. For the entire second quarter, confidence was the highest in almost four years.

Better feelings about jobs and incomes are helping to offset some of the impact of higher rates by giving consumers more confidence to take on more debt. But at the same time, the cost of carrying that debt has fallen to the lowest percentage of aftertax income in a decade, and problem loans are down.

In the first quarter, the percentage of bank consumer installment loans with overdue payments fell for the eighth straight quarter to a 20-year low of 1.74%, says the American Bankers Assn. (chart). The lowest delinquency rate: the popular open-end home-equity lines of credit.

But despite consumers' better finances, higher rates will take a toll on consumers and manufacturers. That's because their biggest impact will be on the demand for rate-sensitive durable goods, especially since those items were the main beneficiary of 1993's refinancing windfall.

Now, however, the Mortgage Bankers Assn. also says that refinancing activity has all but dried up. Its index of mortgage applications for refinancing has plummeted 91% from 1,547.3 last October, when mortgage rates hit their low point, to 133.7 in early June.

Buying plans for rate-sensitive items are indeed down, says the Conference Board. Its June survey also showed that plans to buy autos fell for the second month in a row and that interest in major appliances was weaker. Home-buying intentions are declining, as well.

Those scaled-down plans are showing up in manufacturers' order books. Orders for durable goods rose 0.9% in May, after a slim 0.1% gain in April. Excluding commercial aircraft and defense, two small and volatile sectors, bookings barely rose in May, and they are well below their March level (chart).

With more and more signs of slower growth and with any obvious inflation pressures still absent, the Fed will be hard-pressed to rationalize another rate hike at its July meeting, especially so soon after a half-point hike in both the discount rate and the more important federal funds rate.

As for the dollar, a small boost in rates would do little to alter the underlying reasons for the dollar's weakness. It will not reduce Japan's trade surplus, it will not shrink America's current account deficit, and it will not restore lost international confidence in the Clinton Administration.

Rather than lift rates, the Fed is most likely to continue its intervention efforts when it deems such action necessary as an international show of support for the currency--even though the attempt is often little more than a crapshoot.

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