The Fed Strikes While The Iron Is Cooling

The U.S. economy has had quite a run during the past year--4% growth, 3 million new jobs, and only 2.7% inflation. However, the Federal Reserve knows that this happy combination cannot go on forever. Something has got to give. Based on the new round of tepid data and the Fed's latest boost in interest rates, it looks like that something is going to be growth.

So far, third-quarter growth is already shaping up to be decidedly less brawny than the past year's trend. And this year's tightening of Fed policy will have a delayed effect on the economy, with its full impact not felt until 1995.

After adjusting for price changes, retail sales began the quarter slightly below their second-quarter level. The same is true for housing starts. Industrial production is holding up, but in the face of weaker demand, a lot of production is winding up in retail warehouses, threatening to slow output this fall. All the while, inflation at both the wholesale and retail levels remains as docile as ever.

Obviously, the Fed wasn't looking at this low-inflation landscape during its Aug. 16 policy meeting when it decided to lift money-market rates for the fifth time since Feb. 4, citing "continuing strength in the economic expansion and high levels of resource utilization".

In a decidedly aggressive move, the central bank raised the federal funds rate on overnight interbank borrowing by half a percentage point, to a 21/2-year high of 43/4%--a 13/4-point hike so far this year. It also boosted the discount rate it charges member banks for loans by a like amount, to 4%, in a 7-0 vote (chart). Commercial banks reacted with embarrassing speed, hiking the prime rate by a half-point, to 73/4%, only minutes after the Fed's announcement.

The good news, at least for home buyers, is that the bond market rallied vigorously in response to the hike in short-term rates. The sharp drop in long-term interest rates could explain why the Clinton Administration sounded almost supportive of the Fed's action. The White House believes that lower long rates are much more important to continued growth.

The yield on the benchmark 30-year Treasury bond closed at 7.37% on Aug. 16, a two-month low, which is down from its high of 7.73%, hit on July 11. Bond gains fueled a stock rally, and the dollar strengthened. Given the signs of slower growth, the bond market finally seems impressed by the central bank's inflation-fighting resolve, suggesting that long rates may well stay down.

Bond players particularly liked the Fed's statement that the hikes will be sufficient, "at least for a time," to meet the central bank's objectives. That means another increase will be put off until the Nov. 15 meeting at the earliest--and perhaps until 1995--as long as recent signs of slower growth and tame inflation continue. The pronouncement removes uncertainty over near-term Fed actions, allowing traders more freedom to take positions and make pricing decisions on long-term securities.

Of course, the Fed's moves this year have been closely watched around the world. As a result, preemptive strikes against inflation now seem to be the policy du jour for central banks. The most surprising attacks came on Aug. 11, when the Bank of Italy and Sweden's Riksbank lifted their policy-setting lending rates. By raising rates now, both central banks said they hoped to head off price pressures.

The twin moves suggest that, except for one more cut by the German Bundesbank, monetary policy in Europe is starting to shift toward a tighter stance, especially given the growing belief that the European recovery is developing a little more steam than previously expected.

The most likely candidates for the next hike include Britain, Spain, and Denmark. For the Fed, a globally synchronized monetary policy makes inflation-fighting easier, although higher rates abroad eventually could weaken the dollar in the currency markets.

The generally tame look of the latest price data clearly shows that the Fed is out in front of the inflation curve (chart). The consumer price index rose 0.3% in July, but excluding energy and food, the core rate rose only 0.2%. Energy prices jumped 1.8%, finally reflecting this year's runup in crude-oil prices, and coffee prices soared 22.4% because of the frost damage in Brazil. But those are one-shot increases. In the past year, core inflation is a cool 2.9%, held down by moderation in service prices, especially those for housing, transportation, and medical care.

At the wholesale level, the producer price index rose 0.5% in July, but again, coffee and energy fueled the increase. The only sign of price pressure is at the earliest stages of processing, and even so, there is no indication that it is being passed through to finished goods, let alone to retailers. The core PPI was up a scant 0.1%, and yearly core inflation for finished goods remains essentially zero. The demand-dampening effects of the Fed's rate hike will help to make sure that rising materials prices are not passed forward.

Indeed, past tightening already appears to be cooling off consumer spending. Retail sales fell 0.1% in July, although May and June receipts were revised slightly higher. Weak car buying accounted for all of the month's decline, but nonauto sales managed only a tepid 0.4% gain. Inflation-adjusted retail sales have gone nowhere since February (chart).

If buying does not pick up in August and September, consumer spending will be hard-pressed to match even the second quarter's weak advance, and that would slow growth in the industrial sector by more than what already seems likely.

Industrial production rose only 0.2% in July, but that gain was depressed by a drop in utility output back to normal levels following June's hot weather. Output in manufacturing alone rose a sturdier 0.4%, led by another solid gain in business-equipment production. Factory production would have been up 0.5% if not for a big drop in automotive mutput.

The problem is that, so far this year, factory output of consumer goods has risen at an annual rate of 4.1% while real retail sales are up only 1.3%. That explains the backup in retail inventories. In fact, the overall rise in stockpiles last quarter may have been even larger than the huge increase the Commerce Dept. had estimated in its report on gross domestic product. Inventories held by manufacturers, wholesalers, and retailers rose 0.4% in June, and the May increase was revised up, to 1.2% from 1.1%.

Wholesalers, whose inventories dropped 0.4% in June, apparently pushed their goods onto retailers, where they lay unsold. Retailers' stockpiles ballooned 1.8% in May and 1.4% in June (chart). The July combination of output gains and weak retail buying will only add to the inventory problem.

Past Fed rate hikes also show up in housing. Although housing starts rose 4.7% in July, to an annual rate of 1.42 million, they had dropped 9.4% in June. July starts are not only lower than their second-quarter pace, they are also well below their fourth-quarter peak.

That reflects the rise in 30-year fixed mortgage rates from 6.83% last October to 8.75% in the week ended Aug. 12. The drop in long rates in response to the Fed's latest show of inflation-fighting resolve will help housing at least a little. But it will hardly reverse the effects ef past increases.

In fact, its large half-point rate hike suggests that the Fed is willing to make a policy error on the side of restraint in order to keep inflation under wraps. Has the Fed overdone it? With the economy already slowing down, and with the brunt of the demand-depressing effects of its rate increases still in the pipeline, the central bank is now walking a fine line between controlling inflation and putting the expansion at risk.

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