U.S.: It's Not About The Growth Rate

Instead, Greenspan is watching labor markets for signs of overheating

In all the argle-bargle over what Federal Reserve Chairman Alan Greenspan did or didn't say about interest rates during his semiannual Humphrey-Hawkins testimony before Congress on July 22 and 28, you might have missed a humorous--and important--exchange between the Fed chief and Representative Barney Frank (D-Mass.) The congressman asked, "At what rate can we grow without giving you agita?" Greenspan replied that he would answer that "in a very unusual way." Frank queried, "Like, directly?" To which, Greenspan said, "No, that would give you a heart attack."

Nevertheless, Greenspan's answer was very revealing about his theory of preemptive policy and, thus, about the conditions that will determine the Fed's next move on interest rates. The unusual part was that, while Greenspan's stated policy goal is "maximum sustainable growth," which is determined by the long-run trends in productivity and labor-force growth, he all but conceded that he did not know what that growth rate is. However, he said the number, as it regards policy, "shouldn't be our concern. Our concern should be the imbalances that emerge."

That's not just double-talk. Greenspan was implying that the data may not show the exact optimal growth rate, but they will reveal the imbalances that arise as a result of exceeding that pace. In a ringing endorsement of preemptive policy, he said, "If new data suggest that the pace of cost and price increases will be picking up, the Federal Reserve will have to act promptly and forcefully to preclude imbalances from arising that would only require a more disruptive adjustment later..."

SO WHAT DATA will the Fed be looking at? Without question, Greenspan's chief focus will be on the labor markets, as he looks for evidence that the boom in U.S. spending is straining the economy's ability to cope with it. The chairman suggested that any further drop in the unemployment rate or a reacceleration in wage growth would be red flags. So far this year, strong job growth has heightened consumer optimism (chart), but even extremely tight job markets have not given a signal that the economy is out of balance, mainly because the speed-up in productivity growth has helped relieve pressure on costs and prices.

As Greenspan warned, however, "Should productivity fail to continue to accelerate, and demand growth persist or strengthen, the economy could overheat." It's not just that productivity growth must remain strong: It must continue to grow ever faster. The problem for Fed policy in this particular business cycle, Greenspan said, is that "when productivity is accelerating, it is very difficult to gauge when an economy is overheating." Consequently, he believes that any signs that the economy is starting to boil over will show up first in the labor markets.

Because the speed-up in productivity, from about 1% annually during the 1980s and early 1990s to about 2% in the past four years, is a relatively new phenomenon, driven in part by technological innovation, Greenspan says a key question is whether productivity growth stays at its recent higher rate, drops back, or climbs even more.

On that, the Fed chief gave a strong hint about where he stands: "The business and financial community does not as yet appear to sense a pending flattening in this process of increasing productivity growth." He said that was the impression from corporate executives and that it was also suggested by ongoing upbeat forecasts of corporate earnings.

THE FED'S FORECAST, which projects economic growth in the 3 1/2%-to-3 3/4% range for 1999 and in the 2 1/2%-to-3% range in 2000, appears to embody a slight pickup in productivity growth from the 2% trend in recent years (table). Indeed, productivity in the second quarter, to be reported on Aug. 5, appears to have been quite good, following gains averaging nearly 4% in the two previous quarters.

Ever faster gains in productivity are necessary because demand by consumers and businesses shows no sign of slowing down at a time when foreign demand is starting to pick up after a two-year lull. New orders for durable goods rose 0.3% in June on top of a 0.8% gain in May. And despite higher mortgage rates, June sales of existing homes rose to a record annual rate of 5.53 million (chart), suggesting strong demand for household goods in coming months.

Moreover, consumer confidence, while lower in July, remains historically high. The Conference Board's index dipped to 135.6 in July, from a 30-year high of 139 in June. Also, the percentage of households who think "jobs are plentiful" jumped to 49.8%, the highest ever, suggesting that job insecurity is waning. Greenspan has cited the fear of layoffs as one factor holding down wage pressures in such a tight labor market.

TIGHT LABOR MARKETS aren't the only concern. Another imbalance that Greenspan noted was the shortfall between private-sector savings and investment, which is being filled by foreign investment, resulting in mounting U.S. international indebtedness. Greenspan worries that, as foreign economies revive, capital inflows from abroad "may be difficult to sustain." He warns that without a rebound in U.S. savings, the dollar could weaken and market interest rates could rise. The recent drop in the dollar against the yen and the euro may well be the first signs that foreign capital is not coming into the U.S. in the quantities it had been.

Greenspan also suggested that the Fed will be keeping a close eye on commodity prices, which are generally picking up in response to the firming in international demand. But the signals here may not be as reliable as the signals from the labor markets. Greenspan said that as the increasingly high-tech economy becomes more conceptual than physical, "the actual impact of industrial commodities on the general price level diminishes." However, Greenspan said that commodity prices tend to reflect the order intake and general level of activity in the industrial sector, which he referred to as "a still very significant part of the economy."

U.S.: It's Not About the Growth Rate
U.S.: It's Not About the Growth Rate
U.S.: It's Not About the Growth Rate

One potential sign of imbalance on which Greenspan did not spend much time was the stock market and the possibility of a market bubble. He said that "identifying a bubble in the process of inflating may be among the most formidable challenges facing a central bank, pitting its own assessment of fundamentals against the combined judgment of millions of investors."

Greenspan admitted that even a productivity acceleration, which embodies significantly higher rates of return on capital, does not ensure that stock prices are not overextended. But for now, he seems willing to give the market's exuberance, irrational or not, the benefit of the doubt. Had he said anything else, he might have given investors a heart attack as well.