Dealing With An Explosive Brew The Fed Holds Steady For Now

The nation's business economists, gathered in Washington for their annual confab on Sept. 25-28, had a message for the Federal Reserve: We like your interest-rate hikes this year, but now it's time to cool it. Trouble is, the economists don't expect the Fed to listen.

The National Association of Business Economists' policy survey of 158 members showed that a 67% majority felt comfortable with monetary policy prior to September. That's a ringing endorsement of the central bank's 13/4 percentage-point boost in short-term interest rates since Feb. 4. However, even though 72% expect a more restrictive policy, a hefty 54% think the Fed should refrain from further tightening.

For now, the Fed is taking the economists' advice. A few blocks from the NABE meeting, the central bank's policy committee was gathered in the Eccles Building, deciding rates should stay put. So the next chance for the year's sixth rate hike is now at the Fed's Nov. 15 meeting, unless serious inflation worries crop up in the meantime.

Although the Fed's inaction signaled its current satisfaction with the economy's pace, it is very likely that the central bank did adopt a policy bias toward tightening on Sept. 27. That's a formal decision that notes the Fed's concern about inflation but says that immediate action is not warranted. The agreement gives Fed Chairman Alan Greenspan the discretion to tighten at any time before the November meeting.

If so, the employment report on Oct. 7 becomes a key indicator to watch for signs of an overly robust, and thus inflation-prone, economy. Another important time will be Oct. 13-14, when a bevy of crucial indicators for September hits the news wires, including producer and consumer prices, retail sales, and industrial production. However, with the economy apparently slowing down, the data may not justify a hike.

The economists' cautious attitude toward more rate increases is reflected in the NABE's 1995 forecast, which predicts slower growth with little rise in inflation (table). The economists believe the third quarter will mark a transition from the heady pace of growth since last summer that began to fuel inflation fears.

They expect third-quarter expansion in real GDP to fall to 2.3%, from 3.8% in the second quarter. And there is a good chance that the pace could slip below 2%, which would spark fears that the Fed's inflation-fighting zeal may be harming the economy.

If so, the Fed also would be hard-pressed to justify another rate hike even at its November policy session, especially since the central bank will be meeting only three weeks after the release of the third-quarter GDP report.

The economists think the trigger for the next Fed move will be rising inflation, as measured by the consumer price index. Their forecast calls for 2.7% inflation this year and 3.3% in 1995. The NABE believes it is worth emphasizing, however, that inflation probably has bottomed out for this business cycle, and that the greater risk is that inflation will be higher than expected, rather than lower.

The bright spot in the inflation outlook is labor costs. The forecasters look for the unemployment rate to average 6.2% in 1994 and 5.9% in 1995, about the rate they believe to be consistent with stable inflation. And because of the moderate pace of wages and benefits, combined with productivity gains, the forecasters expect unit labor costs to grow only 1.4% in 1994, picking up to a still modest 2.5% in 1995.

The NABE expects the slowdown in economic growth to be broad, led by the sectors most sensitive to higher interest rates. In 1995, the pace of consumer spending will cool down about in line with overall GDP. Housing will drop off sharply. Business investment will slow from its brawny 1994 pace but continue to power the expansion. And while exports will pick up, the trade deficit will remain a slight drag, because imports will continue to grow.

Already, consumers show signs that they are tiring--and perhaps losing faith in the economy (chart). The Conference Board's index of consumer confidence declined for the third consecutive month in September, falling two points, to 88.4. Respondents were markedly less positive about prevailing conditions and slightly less optimistic about the months ahead.

With higher interest rates already hitting housing demand, the NABE expects little contribution from housing next year. August sales of existing homes fell 1.8%, to an annual rate of 3.9 million (chart). Except for a weather-depressed February reading, that was the lowest level of the year and below the peak hit in December of last year.

The NABE predicts that the nation's manufacturing sector will post especially solid gains over the next two years, with industrial output expected to rise 5.3% this year and 3.5% in 1995. Both gains are well above those for the economy as a whole. Exports and business investment in equipment will lead the factory-sector strength.

Factory orders for durable goods rebounded by 6% in August, after falling 4% in July (chart). Autos, which had accounted for more than half of the July drop, contributed more than half of the August jump. That pattern reflected the July shutdowns for retooling. The pace of orders still shows signs of cooling off, though. Bookings so far in the quarter are no higher than their second-quarter average, and unfilled orders in August fell for the second consecutive month.

Naturally, the National Association of Manufacturers would not like to see higher interest rates impede their progress any more than necessary. A NAM survey of 115 executives revealed massive opposition to any further hikes in short-term rates. And the National Retail Federation recently sent a letter to Greenspan, pleading with the Fed chairman to take it easy.

Still, the NABE economists look for short-term rates to rise, but not by a lot. They expect the rate on three-month Treasury bills to increase from a September average of 4.55% to 5.28% by next December, implying about three-fourths of a point of Fed tightening. Long-term rates already appear to embody expectations of an even greater increase in short rates, so the forecasters expect the rate on 30-year Treasury bonds to end 1995 at 7.75%, a shade below the current level.

If the forecasters are right about economic growth and inflation, one additional half-point rate increase by the Fed in the coming year may well be all that's needed. But since Greenspan has already said that he would prefer policy to err on the side of restraint, there's a good chance the NABE, a raft of industry executives, as well as the Clinton Administration, will be disappointed with the direction of future monetary policy.

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