Did The Fed Overtighten? Not If You Look With Both Eyes

As the economy's landing gets bumpier, a key question is receiving a lot more attention: Has the Federal Reserve overtightened?

Most economists still say no. A few, though, are far more pessimistic, especially the monetarists--those who depend heavily on various measures of bank reserves and the money supply for guidance on future

economic growth and inflation.

The monetarists make a compelling case, especially with the economy slowing so sharply. First-quarter growth in real gross domestic product was revised down to 2.7% from 2.8%, following the fourth quarter's 5.1% gallop. Monthly data suggest that second-quarter GDP growth will be even less, as businesses pare excessive inventories.

In May, new jobless claims shot up (chart) and consumer confidence fell. Construction contracts plunged 10% in April, to a 2 1/2-year low. .The Federal Reserve Bank of Philadelphia and purchasing managers in Chicago both reported slower business activity in their regions in May. And the government's index of leading indicators is falling, pointing to continued weakness down the road.

IN THE MONETARISTS' VIEW, all this malaise is the result of a too-tight monetary policy--and a precursor of the next recession. In today's weak economy, they say, short-term interest rates would be falling if the Fed were not busy draining bank reserves in an effort to maintain its targeted federal funds rate at the current 6% level. Reserves are the raw material that banks use to generate money and credit.

The monetarists point to the unprecedented decline in bank reserves in the past year as evidence of the Fed's choke hold on the economy (chart). As a result, several measures of money growth look exceptionally weak--especially the narrow gauges, which include only currency and deposits used for check-writing.

To be sure, Fed policy is restrictive. For example, the inflation-adjusted federal funds rate, currently at around 3%, is well above its historical average of about 13/4%. Also, the yield curve has flattened considerably in recent months as declining long-term rates have narrowed the spread between long and short rates.

However, these two interest-rate indicators show why there is a vast difference between clamping down to slow the economy and overtightening to squeeze the living daylights out of it. First, the real fed-funds rate remains below the 5%-plus level it hit prior to the 1990-91 recession. The levels touched before the recessions of the '70s and '80s were even higher.

Second, the yield curve, while it is flatter than earlier this year, is by no means flat. For Treasury securities on May 31, three-month bills were yielding 5.81%, 5- and 10-year notes paid 6.07% and 6.29%, respectively, and the 30-year bond yielded 6.66%. One precondition of all past recessions has been an inverted yield curve, in which short rates exceed long rates.

ALL THIS IS WHY Nobel laureate Paul A. Samuelson used to say, "God gave us two eyes so we can keep one on the money supply and the other on interest rates." Besides, money growth alone as a beacon on the economy casts a much dimmer light than it did a decade ago. Financial-market deregulation and globalization have destabilized a once fairly reliable relationship between money and economic activity.

As a result, a given amount of Fed restraint does not squeeze the economy as hard as it used to, especially when measured by reserves and the money supply. Thanks to increased U.S. borrowing from nonbank sources, domestically and from abroad, bank credit accounted for only about a third of private nonfinancial debt last year, down from about half in the mid-1980s.

Moreover, because dollars flow more efficiently through the economy, a given amount of money can support about 15% more output than it used to, based on the turnover rate of the broad M2 money supply, comprised of not only cash and checking accounts but also household money market funds and other short-term savings. So anemic money growth is not the same harbinger of a weak economy that it once was.

Make no mistake: The Fed is bringing this economy down. But so far, the softness is narrow, concentrated in autos, housing, and home-related durable goods. The other 86% of the economy, fueled by capital spending and exports, continues to perk along nicely. The slowdown appears to be primarily an inventory adjustment, most notably by the auto industry. There is no evidence of the cumulative unwinding of activity that is the classic mark of a recession (chart).

That's the message from the Commerce Dept.'s revision to first-quarter GDP. Final demand grew faster than first estimated, rising at an annual rate of 2.5% instead of 1.8%. And inventories grew less than originally thought, especially at retailers. Stockpiles increased by $52.3 billion, rather than $63 billion.

The new mix of GDP lessens the chances of a sharp inventory correction that could severely choke off growth this spring and summer. Still, inventories remain excessive, and many companies will have to work off their extra merchandise. That means further cutbacks in orders and output in coming months.

THE SLOWDOWN, however, is sowing the seeds of its own subsequent pickup. The credit markets, especially the bond market, did a lot of tightening for the Fed last year, and they are now doing a lot of easing. The yield on the benchmark 30-year Treasury bond has fallen from nearly 8% earlier this year to below 6.7%. As a result, 30-year fixed mortgage rates have dropped below 8% for the first time in more than a year, and housing activity is starting to stir again.

Sales of new single-family homes did fall 2.7% in April, to an annual rate of 580,000, but March sales were revised sharply higher. And by mid-May, mortgage applications to buy houses had jumped 44.4% from mid-January, while refinancing applications are also showing some life. After a couple of months of better sales whittle down builders' inventory of unsold homes, construction will be set to add to, rather than subtract from, economic growth in the second half.

Consumers are also likely to show more life. Although the Conference Board's index of consumer confidence dipped to 101.6 in May from 104.6 in April, a reading above 100 has typically been associated with a fairly peppy consumer sector. But job growth for this business cycle has probably peaked, and consumer debt levels are up sharply, so shoppers are not likely to regain their 1994 urge to splurge.

In the meantime, this slowdown has a long way to run, and it's likely to generate a new round of Fed-bashing, as Washington and various business groups join the monetarists in bad-mouthing the central bank's policies. The Presidential candidates will get their licks in, too. But economists who look at the world with both eyes may feel more kindly toward the Fed. In their tea leaves, the current slowdown is not a forerunner to recession but the pause that refreshes.

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