U.S.: Behind The Fedspeak: More Rate Cuts

On Feb. 16, Bill Clinton threw out what amounted to a policy challenge to Federal Reserve Chairman Alan Greenspan via his Chief of Staff Leon E. Panetta. "The President believes there is some room for additional growth," Panetta told reporters. Coming from an Administration that has gone out of its way to make nice with the Fed, the remark sounded like a broadside.

The White House is aware that the economic reports of late have been less than sterling. It sounds like Clinton, angered by the Republicans' rejection of pro-growth Fed candidate Felix Rohatyn, is setting up Greenspan as a scapegoat, just in case the economy turns sour along the election trail.

Indeed, some new economic risks have emerged, and most can be laid at Washington's doorstep. Policy, both fiscal and monetary, is turning out to be much different for 1996 than what economists had generally assumed at the end of 1995. First, a budget-balancing deal, which was expected to push down long-term interest rates, is nowhere in sight. Instead, stingy continuing resolutions, which force some 10% to 15% of the government to operate at about 75% of last year's funding, are a drag on growth.

Moreover, past Fed tightening may be squeezing the economy more than had been presumed--to the point where the central bank has acted recently as if it thinks it is behind the curve on assuring that the economy will not slip into recession. The Fed has cut interest rates faster, and seems likely to cut by more, than had been anticipated.

GREENSPAN ADDRESSED the economy's prospects at length during his semiannual testimony before Congress on Feb. 20-21. He admitted that several depressants were currently weighing on growth. However, the effects of weather and the government shutdown were "transitory," he said, while the more significant drags from reduced government funding and an adjustment of business inventories were "temporary."

For the record, the Fed says the most probable outcome for 1996 economic growth--using the new chain-weighted GDP--is in the range of 2% to 2 1/4%, with stable inflation and unemployment (table). With first-quarter growth widely expected to be weak, the forecast implies growth well above that range later in the year. Greenspan said that imbalances that typically precede recessions did not appear to be present, and that financial conditions support spending.

Greenspan's seemingly upbeat comments sent the financial markets falling flatter than a mobile home in a tornado on Feb. 20. The Dow Jones industrial average dropped 45 points, the fourth daily loss in a row. But bond prices took the bigger hit, as the yield on the 30-year Treasury bond shot up to 6.40%, from 6.24%. The markets believed that Greenspan saw little reason to cut rates further.

THE MARKETS' INITIAL INTERPRETATION, however, may have missed the fine print of the chairman's remarks. In his best Fedspeak, Greenspan appeared to hedge on the side of rate cuts. In the context of future policy decisions, he said that the Fed sometimes feels the need to take out some "monetary policy insurance" when the risks to its forecast fall one way or another.

Given weak data and the Fed's own low-inflation forecast, that comment sounds like Greenspan is ready to err on the side of accommodation, and that chances for another rate cut at the Fed's Mar. 26 meeting are still good. It is inconceivable that Greenspan would risk even a near-recession to achieve any further reduction in inflation, especially when he has already admitted that the consumer price index overstates inflation.

Wall Street took a little different view of Greenspan's remarks in the second round of testimony on Feb. 21. Stocks and bonds both rallied, partly because the Fed chairman himself sounded somewhat more open to the idea of further rates cuts than he had the day before.

Greenspan talked a lot about why the potential costs of cutting rates right now are low. The main reason: Structural forces related to rapid technological change and corporate restructuring are reducing inflationary expectations. But he stopped short of endorsing the notion that the economy's maximum noninflationary growth rate had increased, although he did suggest that productivity, the key component of that speed limit, was understated by the data.

For now, Greenspan made it clear that he has, as usual, a close eye on the data. The trouble is, the numbers, which have been tossed about by government shutdowns, strikes, and a blizzard, do more to obscure the outlook than clarify it (chart, page 31). Although there were no blizzards in February, there were frigid temperatures and flooding, so a clear reading may not be possible until April, when March data are released.

Even so, first-quarter economic growth could still end up near zero, giving the economy bears a chance to growl a little louder this spring.

DESPITE THE LOUSY DATA and the first hints of Fed-bashing by the Administration, the numbers still lack the dire look worthy of the panic button. The industrial sector is genuinely weak, led by carmakers' efforts to cut inventories. But it's not as wobbly as the 0.6% drop in January industrial production suggests. A 6.7% plunge in output of cars and trucks accounted for half of the overall decline, while the blizzard very likely stole the rest--and probably more.

To be sure, auto makers will be a big drag on the economy throughout the first quarter. That's because, even with the steep January production cuts, dealers' stocks still swelled to an 88-day supply at the end of the month, up from an already burdensome 72 days in December (chart). About 60 days is normal.

Elsewhere, manufacturing shows some buoyancy. Factory orders rose a strong 1.3% in December, led by a jump in aircraft orders. But even excluding the volatile transportation sector, bookings in the fourth quarter grew faster than they did in the third.


In addition, foreign trade is a plus for the economy. Despite slower export growth, imports have slowed more, and the U.S.-Japanese trade balance dropped again in January. Construction spending, which is likely to get creamed in January, rose strongly in December. And the index of leading indicators in December posted the first increase since August.

When the economy's current period of weakness passes, there is little to prevent it from resuming at least a moderate pace of growth. But with fiscal policy tighter than expected, and possibly on hold until after the November elections, the Fed seems likely to take out some more "insurance," in the form of lower rates.

That's why the White House should probably go easy on the Fed criticism, veiled or otherwise. It stands to lose a cordial relationship with the central bank in order to get something it very likely would have received in the first place.

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