Now Is The Fed Ready To Stop Tightening The Vise?

No good deed goes unpunished. Neither does a good economy. The fourth quarter's burst of growth capped off the economy's best performance in 10 years, even as inflation remained quiescent. And according to the early data for January, consumers and businesses carried some of that momentum into the new year.

The result of such uplifting news: The Federal Reserve tightened the monetary screws for the seventh time in a year. On Feb. 1, policymakers at the central bank voted to raise the federal funds rate by half a percentage point, to 6%. The fed funds rate, which banks charge each other for overnight loans, has doubled in just a year. The Fed also bumped up the discount rate it charges banks for loans by a half point, to 51/4% (chart).

Fed watchers are beginning to speculate that this latest move is the last, at least for a while, and that the current tightening cycle is now drawing to a close. One reason: scattered signs that past rate hikes are beginning to cool off the economy. Also, more than half of the Fed's tightening in the past year has not had time to filter through the economy.

In its statement regarding the hikes, the Fed said: "Despite tentative signs of moderation in growth, economic activity has continued to advance at a substantial pace, while resource utilization has risen further." That's the first time a policy statement has acknowledged even a hint of a slower economy. But the financial markets reacted negatively because the statement did not give a clearer signal that the Fed was finished tightening.

The 4.5% annual rate of growth in the fourth quarter's real gross domestic product wasn't unexpected, but the Fed was undoubtedly displeased that demand remained so resilient despite its past rate hikes. Final demand grew 3.7% last quarter, slower than in the third quarter, but excluding the ups and downs in defense outlays, demand increased a sturdy 5.1%, faster than in the previous quarter. In fact, the hot items last quarter were durable goods--the very items sensitive to interest rates.

The real head-turner in the gdp report, though, was another huge rise in inventories. Total inventories grew by $68 billion last quarter, after mega-increases of $59.2 billion in the second period and $57.1 billion in the third (chart). That's the largest three-quarter accumulation in a decade. But while the buildups in the two prior quarters were intentional, the yearend increase may have been more than businesses wanted. That's because, according to the Commerce Dept.'s estimate, the biggest gain came during December, when consumer spending began to flag.

The inventory pileup has three implications for 1995. First, most of the extra inventory ended up in the warehouses of wholesalers and retailers. So these businesses will have little need to reorder goods, leading to smaller gains in factory output and jobs in coming months.

Also, look for a lull in the import surge because some of those warehoused goods were made overseas. The import slowdown will help reverse the widening of our trade deficit. In the fourth quarter, imports grew 16%, outpacing the 14.2% advance in exports and widening the net-export deficit by $7.1 billion. The $124.1 billion gap was the largest in seven years.

And last, unwanted inventories will help the inflation outlook. With retailers overstocked, stores will have to cut prices to clear out excess merchandise. That means inflation at the consumer level should remain low.

But for how long? The fourth-quarter gdp numbers indicate that U.S. output of goods and services is now greater than the output possible when all labor and capital resources are fully utilized, according to the Fed's numbers. With demand outpacing the ability to satisfy it, price pressures typically emerge. So inflation hawks are worried that the best inflation news is now behind us. Inflation, as measured by the gdp fixed-weight price index, shows some acceleration, rising 2.9% in the year ended last quarter. That's up from a 2.5% rate in 1994's first quarter.

Price pressures were also on the minds of the nation's purchasing agents in January. The National Association of Purchasing Management said its index of prices paid by manufacturers held near a 15-year high, and that business activity began 1995 with "a good head of steam." The napm's index rose to 57.9% from 57.5% in December.

The reports of industrial price hikes as well as the imbalance between real gdp and its potential are the chief reasons why the Fed acted to restrain the economy even more. So far, though, only a few signs of slowing are emerging. Last quarter, home construction fell at a 2.6% annual rate. The dip would have been larger if not for unusually mild weather. Consumer spending slowed over the course of the three-month period, but buying surged by 4.6% for the quarter.

Consumers saw their real aftertax income jump by 0.7% in December, but they lifted their inflation-adjusted spending by only 0.2% after a modest 0.3% increase in November. They may have started to realize that higher adjustable-rate mortgage payments and large credit-card bills lie ahead.

Consumers gave a mixed appraisal of the economy in January. According to the Conference Board, consumer confidence edged down to 102.1 from December's 103.4. While a reading above 100 indicates an upbeat view, consumers' plans to buy interest-sensitive goods declined. Intentions to purchase a new car dropped sharply, plans to buy appliances fell for the second month in a row, and home-buying plans have been drifting lower since August.

The Fed had to be heartened by the benign pattern of labor costs in 1994. Wages and benefits for civilian workers rose 0.7% last quarter and just 3% for the year--down from 3.5% in 1993, and the smallest gain since the Labor Dept. began tracking employment costs in 1981.

The slowdown in compensation was evident in almost all occupations and industries. Wage growth continued to drop, falling to 2.8% in 1994 from 3.1% in 1993. But benefits staged a more dramatic slowdown (chart), growing only 3.4% in 1994--way below the 4.6% gain in 1993 and about half of the 6.7% in 1990. Labor said the small rise reflected slower growth in health and workers' compensation insurance costs.

However, last year may have been the bottom for labor-cost growth. Hourly wage gains started to edge higher in the second half of 1994. And with labor markets growing tighter, businesses may have to loosen their purse strings and lift pay to attract qualified workers. Even so, the forces of intense competition and increased productivity will keep the growth in unit-labor costs mild even for 1995.

The problem for those hoping to find a job or expand a business is that even a mild acceleration in labor costs may be too much for the Fed. That means the central bank will not stop hiking rates until the economy shows broad signs of slowing down. Only then can the inflation-wary Fed be certain that price pressures are in no danger of bursting out of control.

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