U.S.: Another Hike Done How Many More To Go?

Interest rates may need to be much higher to curb demand

How do you lasso a runaway New Economy? The old-fashioned way: with higher interest rates. But in light of some eye-popping new data, a more disturbing question is emerging: Just how high will rates have to go?

The stunning 5.7% and 5.8% growth rates for real gross domestic product in 1999's third and fourth quarters, respectively, clearly heighten the risk that the U.S. economy is overheating. Now there's new evidence that the costs of both production materials and labor are beginning to pick up (charts), and that inflation itself is creeping higher, based on an important price index in the GDP data.

All this is why the Federal Reserve raised two key interest rates by a quarter-point on Feb. 2. The federal funds rate rose to 5.75% and the discount rate to 5.25%. Wall Street has already built another quarter-point increase into its expectations, as soon as the Fed's Mar. 21 meeting, and many economists expect even more hikes after that.

Indeed, the Fed's statement slanted policy toward the risks of "heightened inflation pressures in the foreseeable future," instead of taking a neutral position, despite excellent productivity growth. Also, keep in mind that policy is now only a quarter-point tighter than it was before the Fed's emergency rate cuts totaling 0.75 percentage point during 1998's market turmoil.

FUTURE POLICY DECISIONS, though, will be complicated by the effect of technology. Apart from inflation worries, interest rates should be higher in an economy where technology has significantly lifted both the rate of return to capital and the risk associated with that return. Real, or inflation-adjusted, interest rates for long-term corporate debt now are a full percentage point higher than two years ago. But that rise has not slowed the economy yet.

Undoubtedly, technology has been a boon for this longest of all U.S. expansions. But financial conditions in both the credit and equity markets are too accommodative to prevent excessively strong demand--that is, demand growth beyond the accepted noninflationary limit of 3%-3 1/4%.

That's because there has never been a business cycle in which so much excess demand has been generated by increased stock market gains, powered mainly by technological innovation. Households are the main beneficiaries of those newfound riches. And Fed Chairman Alan Greenspan has estimated that wealth gains have accounted for as much as a fourth of the economy's 4.3% average annual growth in the past three years.

The wealth effect was easy to see in the latest GDP report. Real consumer spending last quarter posted another huge advance of 5.3%. During the entire year, outlays rose 5.4%--accounting for 3.5 points of the economy's 4% growth--while income grew only 3.7%. Wealth gains bridged that gap. Unless, or until, the stock market flattens out, consumers will remain the locomotive of this speeding economy.

The Fed can at least take comfort that housing, which declined in both the third and fourth quarters, is showing the effects of higher mortgage rates. But it's a slow ebb. Unusually mild December weather heated up the month's new-home sales and overall construction outlays. The January data should look much chillier, though.

Another source of comfort: Some precautionary Y2K inventory building and spending effects appear to have distorted growth during the last quarter, as did a one-time surge in federal government outlays that added nearly a point to the quarter's growth rate. Outlays for equipment and software slowed sharply, likely reflecting some temporary, wait-and-see cutbacks in tech investment, but they may pick up again in the first quarter. Also, the pickup in inventory growth was not especially large, given the very low level of stockpiles relative to demand. On balance, any post-Y2K impact on first-quarter GDP should be small.

INDEED, FIRST-QUARTER GROWTH is off to a solid start. Durable-goods orders jumped sharply in December, and the order backlog is growing rapidly. In January, motor vehicle sales were spectacular and the nation's purchasing managers reported good industrial growth. But they also noted a continued acceleration in the prices they pay for materials. The purchasers' price index rose close to a five-year high.

Businesses aren't just paying more for materials, however. The employment cost index (ECI), which covers wages, salaries, and benefits, rose 1.1% in the fourth quarter vs. the third, well above expectations. After last year's slowdown, overall labor costs are speeding up again in the face of ever-tighter labor markets. In the most recent three quarters, the ECI has increased at an annual rate of 4.1%, the fastest in any such period since 1991.

Although wage growth remained fairly steady, the fourth-quarter rise reflected an acceleration in benefits, mainly health care. Benefit costs rose 1.3%, the largest quarterly jump in nearly seven years. Also, in June, the Labor Dept. will add data on hiring and referral bonuses to better reflect the compensation packages offered to workers. That move will only add to the upward pressure on the ECI. Labor is also looking into adding stock options, which are surely boosting labor costs, to the ECI. A survey by consulting firm Watson Wyatt Worldwide shows that 19% of employees were eligible for options in 1999, up sharply from 12% in 1998.

IN ADDITION, a hint that inflation itself has bottomed out can be found in the price index for consumer spending in the GDP report. Greenspan said last year that the index was a "far superior measure of true underlying inflation" than the consumer price index. One reason is that an ongoing series of adjustments to the CPI--without adjusting past data--has imparted a downward bias to the CPI trend, making it difficult to spot a turning point if inflation rises.

U.S.: Another Hike Done--How Many More to Go?
U.S.: Another Hike Done--How Many More to Go?
U.S.: Another Hike Done--How Many More to Go?

Based on Greenspan's preferred measure, consumer inflation last quarter, excluding energy and food, rose at an annual rate of 2.2%, the largest quarterly rise in 4 1/2 years. Compared with year-ago levels, this core price index rose 1.5% at yearend, but it bottomed out at 1.2% in the second quarter of 1998, while the core CPI continues to head down (chart). If inflation is crawling higher because demand is outpacing the economy's ability to meet it, then price increases will continue to pick up until the economy slows substantially.

Although the best news on inflation may have passed, any uptick should be slow. The purchasers, for example, noted difficulty in raising their product prices. But monetary policy conducted at a leisurely pace could be good and bad. Gentle inflation may obviate the need for any large hikes in rates. But a series of small quarter-point moves would be like water torture for the markets--inflicting pain drop by agonizing drop.