Serene At The Fed?

With bond traders worrying up yields, it may leave rates alone

It's not hard to figure out why interest rates are shooting up. Sure, inflation is still hibernating, but signs of hypergrowth abound. Fourth-quarter gross domestic product was revised upward to a stunning 6.1% annual rate on Feb. 26. On Mar. 1, the National Association of Purchasing Management reported that manufacturing expanded in February for the first time in nine months. Personal income in January jumped 0.6%. The Conference Board is recording the highest-ever consumer confidence ratings, and its index of leading indicators leaped 0.5% in January. Then, on Mar. 2 and 3, Detroit reported that vehicles sold at a torrid 17 million-unit annual rate in February.

With all this good news piling up, the bond market has crumbled. Traders are convinced the Federal Reserve will have to boost interest rates to cool off an overheated economy. On Mar. 3, yields on 30-year Treasury bonds hit 5.7%. That's nearly a full percentage point above their low last fall, after the Fed cut three times to head off a recession in the U.S. The cuts did the trick--and more.

When Fed Chairman Alan Greenspan offered his assessment of the situation in congressional testimony on Feb. 23, traders saw a signal that the central bank would hike. That pushed yields up. They rose again on the eve of the Mar. 5 jobless report, as traders braced for further signs of overheating. If the long bond keeps rising and passes 6%, analysts warn, the stock market could tumble and consumers could cut back. That could cause a more abrupt slowdown.

DOWNSHIFTING. What is more likely is that the markets are doing the Fed's work for it and the economy will downshift out of the hot-growth danger zone. Fed forecasters and members of the National Association for Business Economics figure that if rates hover between 5% and 6%, GDP growth will settle down to a comfy 3% rate this year. Inflation will remain in check, and the Fed will sit on its hands. "It's a fairly serious turnaround from what the markets are thinking right now," says Nicholas S. Perna, chief economist at Boston-based Fleet Financial Group Inc.

The rise in long-term rates since the start of the year is already having a moderating effect. New single-family home sales fell 5% in January from December, as conventional fixed-rate mortgages edged back up toward 7%. Another factor for housing is the skittish performance of equity markets--which aren't delivering the huge capital gains that helped home buyers last year. Rising rates and a flat stock market should be enough to "cause the housing market to tail off," says former Fed Governor Lyle E. Gramley, consulting economist at the Mortgage Bankers Assn. That could ripple down to everything from furniture to garden equipment.

Inside the Fed, senior forecasters believe that despite the fast February sales, a modest slowdown in actual production could moderate first-quarter growth to a 4% clip. That's because production soared in the fourth quarter as General Motors Corp. recovered from a summer strike, and inventories were restocked. Meanwhile, the computer industry is lowering its sales forecast for the first quarter.

Then shave off an additional half-point of growth from flattening demand for exports, as a weakening Europe and a further contraction in Japan make the dollar stronger and U.S. products abroad less attractive. The National Association of Manufacturers (NAM) expects the U.S. trade deficit to swell by $40 billion this year, to a record $209 billion--a heavy-duty drag on the economy. The bottom line: Growth should slow from stupendous to merely great.

And a Fed rate hike would go from likely to unnecessary. Even hawkish Fed Governor Laurence H. Meyer, who relentlessly worries about tight labor markets igniting wage inflation, can envision such a scenario. In a Feb. 25 speech, he said it's quite possible that "the economy will make a successful transition to a more sustainable state without policy intervention."

Still, if rapid growth persists in the first half, the rush to head off Y2K computer glitches could provide a brake in the second. Some economists say that the surge in business spending on Y2K equipment and software that began last year will abate in the fall as companies eliminate their bugs. On Mar. 3, the NAM released a survey of its members that showed most expect to complete Y2K repairs by summer. "A slack-off of demand points to an overall slowdown in the fourth quarter" and in 2000, predicts former Fed Governor Lawrence B. Lindsey.

The Y2K scare also could keep the Fed from tightening toward yearend because it doesn't want to risk a short-term liquidity crisis if bank computers malfunction. Already, Greenspan has promised to flood the system with $50 billion in extra cash to prevent any financial paralysis come the new year. Top Fed officials concede that if they don't tighten by summer, they'll likely forgo any hikes for the rest of the year.

"DARKER AND DARKER." That would be just fine with Greenspan, who privately sees little justification for a rate boost, according to sources familiar with his thinking. For one thing, despite heartening evidence that parts of Asia are slowly recovering from a deep recession, the Fed chairman is still fearful that a new financial shock could send the global economy back to its sickbed. "The international situation is still very much on his mind," says one Greenspan confidant.

One thing the Fed chief isn't overly worried about is the prospect that inflation will shoot up because the economy keeps growing faster than its potential, which the central bank once defined as 2.5%. Using his own calculations, Greenspan has concluded that since the early 1990s, the real productivity rate is running above 2%, nearly double the rate of the 1970s and '80s. That explains why the economy has been growing faster than 3% a year since 1996 without driving prices higher. In fact, the Fed chief credits productivity gains and technological advances for driving some prices--such as computers--lower.

Inflation has also remained tame because prices for oil and other commodities fell. Fed officials don't expect such large drops again in 1999, even though there is new weakness in grain futures. Indeed, says ex-Fed Governor Lindsey, now a top economic adviser to Texas Governor and Republican Presidential candidate George W. Bush, Greenspan may have to worry less about inflation and more about falling prices: "If you paint every country facing deflation in dark colors, the world is becoming darker and darker," Lindsey says.

Maybe bond traders should think about that, take a deep breath, and get over their phobia about a coming Fed rate hike. Certainly, Greenspan and his colleagues believe the run-up in bond yields is a misreading of their thinking, though they are privately cheered that the overreaction has temporarily cooled off an exuberant stock market. For now, the monetary mandarins on Constitution Avenue are betting on a return to moderate growth and stable rates that will give them nothing to do in '99. That scenario should make that frenzied bond market chill out.

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