Why The Fed Saw Clear And Present Danger

When the Federal Reserve stunned Corporate America with a half-point boost in interest rates last May, many executives worried whether an economic expansion that appeared to be losing steam could take the hit. And the Fed's hints that it wouldn't be raising rates again for a while suggested that even the central bank thought it might have been pushing the envelope.

Now comes the real surprise--just how resilient the economy is proving to be. It shrugged off that May rate hike with a surge in industrial production, job growth, and a wave of new borrowing that surpassed most forecasts (charts). No wonder the Fed was forced back into action on Aug. 16, when its policymaking Federal Open Market Committee approved another half-point boost in the federal funds rate--the rate banks charge each other for overnight loans. The increase, to 4.75%, was accompanied by a half-point hike in the discount rate the Fed charges banks directly.

But unlike the Fed's four previous rate hikes, which prompted hand-wringing in executive suites and the Oval Office, the latest gambit of Fed Chairman Alan Greenspan is stirring far less fear of overkill. Why? Because fewer executives see consumer confidence as being as fragile as it was last spring. Rather, the economy seems so robust that economists are raising their growth estimates--and some anticipate yet another half-point rate boost later this year, probably after the November elections. "The low interest rates of '93 have clearly given this economy powerful momentum," says Paul W. Boltz, chief economist for T. Rowe Price Associates Inc. "The Fed needs to provide more tightening to restrain this beast."

CAR CRUNCH. Even some rate-sensitive industries are applauding the Fed's action, in hopes it can cool a surging economy. Chrysler Corp. executives hope that rising rates will temper consumer demand, which is outstripping auto makers' ability to supply the market. With the industry unable to retool its factories fast enough, some models have been in short supply. The Fed's latest move "is the best thing that could happen," says Chief Executive Robert J. Eaton.

Equally astounding, Clinton Administration economists are enthusiastically embracing Fed policy in private. They, too, fear an overly vibrant economy could create an inflation problem if not restrained now. This sentiment was clearly shared by the new Clinton appointees to the Fed board, Alan S. Blinder and Janet L. Yellen, who joined in the unanimous decision to hike the discount rate. "We're creating jobs at a pace that just a year ago we thought wasn't possible," admits one Administration economist. If the Fed didn't move now, Clintonites figure, Greenspan & Co. would have to hit the brakes just before the 1996 elections.

To be sure, some business people think the Fed is overreacting. Paul Huard, senior vice-president of the National Association of Manufacturers, worries the Fed's action "may be a case of too much, too soon." A few executives contend the central bank may be moving too aggressively at a time when price pressures remain at low ebb. "Five rate increases seem a little extreme," says Jeffrey A. Banaszynski, European sales manager for Allen-Bradley Co., a maker of factory automation gear. "If you take apart the indicators, there's no strong inflationary trend."

NOW HIRING. Technically, that's true. Even the Fed would concede that there are only inflationary whiffs in the air today. But Greenspan is convinced that vigorous growth now would lead to inflation next year. And he sees anecdotal evidence of troubles ahead on the price front. Exhibit No.1: the rash of new hiring, which has sparked modest acceleration in wage growth. The economy is on pace to add more than 3 million jobs this year, and only impressive productivity gains by corporations have kept unit-labor costs under control. Greenspan has warned that wage pressures could build if spot labor shortages spread across the country.

Centex Corp. can vouch for that. The Dallas-based homebuilder has been scrambling to find bricklayers in Texas and carpenters almost everywhere else, although it expects the shortages to ease with higher interest rates already cooling home sales. And in Charlotte, N.C., where the unemployment rate has dipped below 4%, Wilton Connor Packaging Inc. has gone to unusual lengths just to fill half of the 90 available jobs: The company is hiring high school students and autistic workers for packing jobs and is employing prison inmates on work release to make boxes. "We were looking for folks that could be with us for some time," says company founder Wilton Connor.

Such activity explains why some analysts doubt the Fed's Aug. 16 move will slow the economy to the 2.5% growth rate the central bank considers ideal for sustaining a noninflationary expansion. David M. Jones, chief economist at Aubrey G. Lanston & Co., believes the second-quarter growth rate may have hit 4.2%, well above the government's initial 3.7% estimate. And with the auto industry prepared to boost production this fall, Jones believes the economy could grow as much as a full point more than the 2.5% many economists previously forecast.

EARLY WARNING. The Fed also is concerned about a recent surge in credit demand that would fuel inflation. Consumer loans, which were rising at a 14.4% pace this year, surged 25.8% in July. And commercial and industrial loans shot up 17% in July, besting a 9.6% rate in the year's first six months.

The Fed may find in such data confirmation that it can't wait until inflation shows up in the government statistics. While the widely followed consumer price index shows few worrisome signs of inflation as of now, Greenspan contends the central bank's views are influenced more by such key early warning signals as commodity prices.

There, the news isn't reassuring: The Journal of Commerce's commodity price index is up 12% since January. And prices of core intermediate goods have risen for three straight months--at an annualized 5.2% rate, the highest level since 1987, notes First Union National Bank economist Mark P. Vitner. Even the CPI, which has risen 2.8% over the past year, is unnerving some economists, who have noticed that the index has climbed at a 3.3% annual rate since May. "The best inflation news is behind us," says St. Louis economist Laurence H. Meyer.

Those first troubling glimmers of inflation, combined with a strong economy, could force Greenspan to raise rates again come fall. This time around, he got considerable support from the markets, key business interests, and the Clintonites for taking action. The question now: Will that support hold up if he decides to drop the hammer again?

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