U.S.: The Fed Moves, The Market Grooves

Wall Street likes the preemptive strike-but is it really a one-shot hike?

O.K., class, repeat after me: 2+1=3. Call it Alan Green-span's new math, which the Federal Reserve chairman unveiled in his June 17 congressional testimony. That is to say: 2% productivity growth plus 1% growth in the labor force equals the U.S. economy's 3% maximum noninflationary growth rate. Why is this lesson important? Because the June 30 hike in interest rates suggests that it may well be the key to monetary policy in the quarters immediately ahead.

The old math, which many economists are abandoning, assumed slower productivity growth, and thus a noninflationary limit of about 2 1/4%. Although the precise numbers for productivity and the labor force continue to spark debate over what the economy's growth limits really are, Greenspan now has given a ballpark figure of where he himself stands on the issue. That's important because maximum noninflationary growth is Greenspan's often-stated goal for policy, and apparently, the Fed has decided that the economy's 4% growth rate has become too hot to handle.

As a result, the Fed lifted the target level for its federal funds rate, the overnight rate for interbank borrowing, by a quarter-point, to 5%--the first rate hike since March, 1997 (chart). Policymakers chose to leave the largely symbolic discount rate at 4.5%. And in a move that eased the markets' fears about the urgency for further hikes, the Fed shifted its official policy predisposition to neutral, from one that had been leaning toward tightening. Both stocks and bonds rallied sharply. The Dow Jones industrial average jumped 155 points on the day, and the 30-year Treasury yield fell to 5.96%.

HOWEVER, THE MARKETS may be reading too much into the shift to a neutral bias. The Greenspan Fed has always changed its official policy stance back to neutral after lifting rates. Moreover, the last sentence of the Fed's statement left the door open for further hikes if needed: "The Committee, nonetheless, recognizes that in the current dynamic environment, it must be especially alert to the emergence, or potential emergence, of inflationary forces that could undermine economic growth." And unless the data show that the economy is slowing to the 3% gauntlet that Greenspan has thrown down, more rate hikes may be forthcoming.

Further tightening is likely especially since last fall's three-quarter-point rate cuts added significant stimulus to an already hot economy. In his June 17 testimony, Greenspan referred to last fall's downward adjustments in rates as an "emergency injection of liquidity." But with Asian economies now stabilizing, and with the outlook for world growth improving, at least partly, and perhaps all, of that extra liquidity is not needed, particularly since U.S. growth continues to barrel ahead. Indeed, the Fed said that "the full degree of adjustment is judged no longer necessary."

Keep in mind that last July, before the emergency easing, the Fed leaned toward tightening, given the economy's strong growth and the drop in the unemployment rate to 4.5%. Since then, the economy has grown at a 5.2% pace in the fourth and first quarters, and the jobless rate has dropped further, to 4.2%. With the economy growing at a 4% pace, the jobless rate would very likely dip below 4% by the end of the year, a rate all economists agree would spark inflation.

Further labor-market strains were the fear that led to last summer's leaning toward higher rates. And despite the Fed's acknowledgment that "strengthening productivity growth has contained inflationary pressures," it remains the Fed's biggest fear. Even with the recent slowing in wage growth, that concern was explicit in Greenspan's June 17 remarks. "Should labor markets continue to tighten," he said, "significant increases in wages in excess of productivity growth will inevitably emerge." He clearly endorsed preemptive policy as a means to thwart such pressures, and preemptive action is exactly what the Fed took on June 30.

THE DRIVING FORCE behind the labor-market tightening is the unrelenting strength in domestic demand, led by consumers. The problem is that the latest readings for household outlays and confidence show no sign that consumers are cutting back (chart). And the economy will not slow down until consumers do.

Households in June were the most upbeat they have been in 30 years. The Conference Board's Consumer Confidence Index rose for the eighth month in a row, to 138.4, as households gave an improved assessment of their present economic situation, as well as their view of the next six months. The June increase in confidence was significant because the index has now regained all of the ground lost last fall amid the global and U.S. financial market turmoil.

Consumers continue to spend at a pace in excess of their income growth, primarily because of wealth gains from rising stock values and home prices. Greenspan says that such wealth accounts for one percentage point of the economy's 4% growth, and that even if the growth in capital gains ends soon, enough stimulus from this source remains in the pipeline to fuel outsized consumption growth for months to come.

MOST RECENTLY, inflation-adjusted consumer spending on goods and services jumped 0.6% in May, after dipping 0.1% in April. Second-quarter outlays are on track to grow at an annual rate of between 4% and 5%--less than the first quarter's blistering 6.7% pace, but a good deal faster than the 2% to 3% pace at which real aftertax income appears to be growing.

As a result, the saving rate continues to plumb deeper into negative territory (chart). Last fall, for the first time in the postwar era, U.S. households as a whole began to spend more than the income they were generating. And in May, the saving rate fell to a record low of -1.2%, as consumers allowed stock market gains, which are not counted in the personal saving rate, to supplant more traditional forms of saving.

U.S.: The Fed Moves, the Market Grooves
U.S.: The Fed Moves, the Market Grooves
U.S.: The Fed Moves, the Market Grooves

The first victim of the Fed's tightening is likely to be housing. Rising mortgage rates may already be crimping demand, given that sales of both new and existing homes fell sharply in May. Since the end of April, 30-year fixed mortgage rates have risen from 6.9% to 7.6%, according to the Federal Home Loan Mortgage Corp. New home sales fell 5.1% in May to an annual rate of 888,000, and the inventory of unsold homes relative to demand rose to the highest level in a year and a half, a sign that new starts may begin to slow.

Of course, that seems to be exactly what the Fed is looking for. Regardless of whose math you believe, Greenspan & Co. have given us fair warning: If economic growth doesn't quickly slow down to a less rambunctious pace, the policymakers will be back with further rate hikes to make sure it does.

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