The Economy: The Case For A Soft Landing

Greenspan believes consumption is coming under control

If anyone should be worried about where the economy and financial markets are headed, it should be Federal Reserve Chairman Alan Greenspan. After ending the millennium with a bang, the economy shows scant signs of slowing despite three interest rate hikes by the central bank last year.

But even as the yield on 30-year Treasuries is being pushed to levels not seen in 2 1/2 years, confidants say the central bank chief is serene, even optimistic. Why? Because despite the wildly gyrating Nasdaq and predictions that fourth-quarter gross domestic product could top 5%, Greenspan believes the pieces are falling into place for the Fed to engineer a much-awaited satin-soft landing for the high-flying U.S. economy.

UNDER CONTROL. The key reasons: The broadest measures of stock wealth, such as the Wilshire 5000 index, are no longer growing much faster than personal income (chart). Coupled with the slight chill brought to the housing market from higher mortgage rates and the relentless rout in the bond market, the fabled wealth effect---the boost to consumption from higher asset values--may be finally coming under control. And in Greenspan's view, without the wealth effect, it is much less likely that the economy will continue to grow at an unsustainable rate.

To be sure, the Fed has anticipated a slowdown in the markets and the economy in each of the last three years, and it hasn't occurred. The same thing could happen again. If the economy keeps growing faster than the Fed's 3 1/2%-to- 4% speed limit, that would put upward pressure on inflation. A sharp rebound in growth overseas, as many economists expect, could also spur inflation. Given these risks, a quarter-percentage-point rise in the key interbank federal funds rate at the central bank's next meeting on Feb. 1-2 seems assured. But at least for now, it seems less likely that the Fed is about to embark on a yearlong mission to lift rates by a full percentage point or more from their present level of 5.5%.

It seems the three earlier rate hikes may finally be starting to have their intended effect. While most investors and cable news commentators have been transfixed by the ear-popping rise of the Nasdaq, the gains in the broader stock market have slowed. From mid-1997 to mid-1999, the Wilshire 5000 stock index--which includes virtually all U.S.-headquartered, actively traded common stocks--rose by 44%, compared with only 12% for personal income. That gain in the market helped consumers feel richer and sent them rushing to stores and online e-commerce sites, boosting consumption in excess of income--a sure recipe for inflation. But since the summer, the Wilshire index has risen only slightly faster than personal income. If that continues, it becomes less likely that the stock market will generate an overheated economy.

Meantime, rising rates are starting to dampen some sectors of the economy, including housing. New home sales fell 7% in November. Another sign of more temperate growth: The pool of available workers, a favorite Greenspan statistic, isn't shrinking as fast. For the past five months, in fact, it has held steady at 5.5% of the working age population.

That doesn't mean Greenspan and his fellow Fed policymakers can afford to relax. At the top of their concerns: the still-volatile stock market. If stock prices go through the roof this year, the Fed's hopes for a smooth landing for the economy go out the window. The trouble, some experts say, is that the Fed's policy of small interest- rate increases may not be enough to rein in eager investors afraid to be left out of the next big surge in prices, particularly of tech stocks. "This is a trial-and-error process," says David Jones, chief economist at Wall Street broker Aubrey G. Lanston & Co. "It might not work given the wildly bullish psychology we've seen at times on Wall Street."

BIG BOUNCE. So what matters most at the next Federal Open Market Committee meeting is not only how much the central bank hikes, if it hikes, but what the Fed has to say about any move. Indeed, the Fed is retooling its disclosure policy--including its announcement of the "bias"--in time for its next meeting to communicate its aims more precisely.

Another potential pitfall for the Fed: a surprisingly strong rebound overseas. In recent years, a weak global economy provided a safety valve for the exuberant U.S. economy, since any excess demand could be met from imports. But with Asia and Europe coming out of the doldrums, some Fed policymakers reckon the turnaround overseas could boost U.S. economic growth by nearly a full percentage point this year. That would put more pressure on domestic markets.

And unlike in past years, the Fed is not getting any help from fiscal policy in reining in the economy. With President Clinton and Congressional Republicans colluding to bust the budget caps on spending in everything but name, the federal budget should end up boosting growth slightly this year, rather than holding it back.

Ironically, even as the Fed frets about the markets and the economy overheating, it also must watch for another type of danger: a sudden stock market crash. With high-tech share prices having climbed to levels increasingly divorced from such fundamentals as price-earnings ratios and interest rates, some Fed insiders are concerned about the financial and economic implications of a sudden market crash. "The risks of a crash are growing," says former Fed official Lyle Gramley, now an economic adviser to the Mortgage Bankers Assn.

The Economy: The Case for a Soft Landing
The Economy: The Case for a Soft Landing

Perhaps. But no matter which way the market goes, steering the economy to a soft landing won't be easy. Princeton University Professor Alan Blinder, who was at the central bank when the Fed engineered a soft landing for the economy in 1994-95, says the Fed has to be both lucky and good to pull it off a second time. "Coming into an airport, a pilot can do all the right things, but if he gets a severe downdraft the plane is still going to hit the runaway very rudely," Blinder says. "You both have to get the settings right and be lucky." But so far, it looks like the Fed will be able to get the economy home safely again.

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