It's Harder To Hit The Brakes

It's coming, and there's nothing you--or even the Clinton Administration--can do to stop it. There's an economic slowdown in your future. That's what the Federal Reserve wants, and the Fed almost always gets its way.

But the dynamics of braking the economy have changed, and it's going to take a much tighter policy to bring growth down to the 2 1/2% or less that the Fed believes is cool enough to keep inflation from boiling over. A new set of structural forces is conspiring against the central bank's efforts: the shrinking share of the U.S. economy influenced by short-term interest rates, the explosion of nonbank credit, and the growing role of global financial markets and foreign demand are prying loose the Fed's once-absolute grip on the economy (charts).

The Fed already has hiked short-term rates by an aggressive 1 3/4 percentage points since Feb. 4, and another move at its Nov. 15 policy meeting is now a foregone conclusion. "Market pressures already demand at least a half-point increase," says economist L. Douglas Lee at NatWest Securities Corp., and many Fed watchers believe an even bigger hike is possible. After all, third-quarter real gross domestic product rose a surprisingly sturdy 3.4%, lifting growth in the past year to 4.3%.

INFLATION FEARS. That hike won't be the last. Less than a year ago, a 5% federal funds rate--set by the Fed on overnight interbank borrowings--seemed wildly unlikely. Now, economists are talking about fed funds at 7.5% by yearend 1995. One immediate reason: signs of inflation. The vibrancy of the October employment report suggests that wage pressures are starting to build. That alarming trend echoed the Fed's Nov.2 Beige Book, a report prepared for each policy meeting. So even if Fed Chairman Alan Greenspan's ever-cautious style limits the increase to a half-point, chances are rising that he won't oppose another half-point boost at the Dec. 20 meeting.

Beyond the monthly data, though, is a more fundamental economic shift that may force Greenspan & Co. to lean harder on the rudder. Nowhere is that clearer than in the credit markets, where increased borrowing from nonbank sources have struck at the heart of the Fed's loss of control. Corporations are going directly to the markets, both at home and abroad, thumbing their noses at the Fed's attempts to choke off credit supplies. Since 1989, commercial and industrial loans from banks have fallen by $23 billion, while commercial paper has surged by $60 billion. On the whole, bank credit will account for only 36% of private nonfinancial debt in 1994, down from 50% in the mid-1980s.

As much as two years ago, Greenspan himself admitted that credit wasn't flowing through the banking system the way it used to do. As a result, he said, the link between the economy and the money supply had changed. That's evident from the record high velocity--or turnover rate--of the broad M2 money supply. Because dollars flow more efficiently from consumers to businesses to banks, a given amount of money can support about 14% more output that it used to. So the Fed has to squeeze M2 much harder now to reach its policy goals.

That's especially true since the economy's interest-rate-sensitive goods-producing sector is slowly shrinking. The growing service sector is relatively insulated from rates: Consumers generally don't forgo medical exams or postpone car tune-ups because rates are rising. This shift is another reason why the Fed will have to clamp down especially hard on goods producers to slow the economy overall.

But perhaps the biggest structural change challenging the Fed is the loss of national boundaries. Global markets for everything from home computers to corporate equities to government bonds mean "the Fed just doesn't have the control over the economy it once thought it had," says Donald H. Straszheim at Merrill Lynch & Co.

Fed policy affects domestic demand--but foreigners now buy a massive chunk of U.S. output. This year, the U.S. will export a record 22% of its output of goods, up from only 13% eight years ago. And as the recovery jells in Europe, traditionally the U.S.' biggest export market, that share is sure to hit another peak next year. "Trade will offset any dampening that the Fed has built into domestic demand," says Charles Lieberman at Chemical Securities Inc.

The Fed has to fight the global economy on another front, too. America's ever-growing appetite for imports has created a structural trade deficit that is sinking the dollar, a decline compounded by the growing demand by American investors for higher-yielding foreign assets. Don't like the price-earnings ratios on New York's Big Board? Park your money in the Hong Kong exchange or the Paris bourse.

WORLD TRAVELERS. The resulting net outflow of capital from the U.S. means that America is not generating the funds necessary to finance its trade gap. "Last year, we transferred financial resources abroad equal to 3% of GDP," says William Sterling, an international researcher at Merrill. "That's nearly twice the size of the Marshall Plab after World War II."

For the Fed, the only option to achieve a real strengthening of the dollar is to lift U.S. interest rates high enough so that the prices of dollar-denominated assets become more attractive.

The new world financial order, along with the supplanting of services for goods in the U.S. economy, means that the Fed can't be as certain about the ultimate impact of its policy moves. That raises the odds that the Fed could touch off a recession. At the very least, it will be a bumpy ride. As one European central banker puts it: "Even if the one pair of brakes the Fed has hasn't seemed to be working that effectively, it's still the only pair of brakes they have. And they'll still have to use them." Greenspan has stated his preference for erring on the side of restraint as he steers the economy. That said, it's a good idea to keep your seat belt snugly fastened for the trip ahead.

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