U.S.: Another Tap On The Brakes May Not Be Enough
This business cycle is starting to take on a look reminiscent of past cycles: The Federal Reserve is tightening monetary policy to cool off excessive growth in demand that could cause inflation to heat up. At this point, one of two things usually happens: The Fed lifts interest rates just enough to slow growth and relieve inflationary pressures, or it tightens too much, bringing the expansion to a halt--or worse.
Until recently, chances that the Fed could bring the economy down for a soft landing have been good. That's because costs of labor and materials have been under control and productivity gains have helped to offset cost increases. Also, consumers' and companies' expectations of inflation have been effectively squelched. Under those conditions, a little preemptive tightening might have been all that was needed.
Not anymore. Based on the surprisingly hawkish comments from Fed Chairman Alan Greenspan during his semiannual report to Congress on the economy and monetary policy on Feb. 17 and 23, the economy appears to have crossed even Greenspan's very accommodative line, and another rate hike on Mar. 21 seems assured. He now says that demand growth, powered especially by wealth gains, is exceeding the economy's ability to meet it, and that the realignment of overall demand with potential supply "seems more pressing today" because the imbalances are cumulating.
Depending on how advanced this process is, economics tells us that growth will have to slow to a pace below the economy's noninflationary trend for a good while in order to reverse the inflationary pressures. Said another way, if the unemployment rate has now dropped below the level that is consistent with wage and price stability, then the unemployment rate will have to rise in order to restore that stability.
THE KEY QUESTION: How hard will the Fed have to squeeze? Based solely on the Fed's forecast for 2000 (table), the answer would be, not much. The Fed generally expects economic growth in the range of 3 1/2% to 3 3/4%, with the rates for both joblessness and inflation holding steady. By definition, that would mean the economy's sustainable, noninflationary pace is as high as 3 3/4%. If so, then growth would not have to slow very much to rebalance demand with supply.
The trouble is, for the first time in years, risks are cropping up in the inflation outlook. Clearly, inflation is under control as of January. Producer prices of finished goods were unchanged from December, and core prices, which exclude energy and food, fell 0.2%. A sharp drop in tobacco prices skewed those results, though. Excluding that, finished goods prices rose 0.2%, with core prices up 0.1%. Also, the consumer price index increased a tame 0.2%, as did the core CPI.
However, the CPI may not be the index to watch for signs of an inflation upturn. In fact, it has fallen out of favor with the Fed, which now uses the price index for personal consumption expenditures in the GDP report for its official forecast. Greenspan has said that this is a "far superior measure of true underlying inflation."
One reason is that ongoing adjustments to the CPI, without adjusting past data, are biasing the index downward. That makes it difficult to spot an upturn in inflation. In fact, inflation using the Fed's preferred measure, excluding energy and food, appears to have bottomed out in the second quarter of 1998, while the core CPI continues to trend down.
SOME TROUBLE IS BREWING further back in the production process: Core inflation for crude goods is the fastest in 4 1/2 years, the core rate for intermediate goods is at a four-year high, and the trends in both are straight up. Moreover, core intermediate prices are now growing faster than core finished-goods prices, suggesting that cost pressures may soon work their way into finished goods (chart). The longer overall demand continues to exceed supply, the greater the likelihood that cost pressures will feed into final pricing.
And that's true even without considering $30-a-barrel oil, which will start to show up in the February price indexes. Although the Fed will be more concerned about price pressures generally, the specific case of oil is still worrisome for Greenspan, who is mainly concerned about low inventories of oil and oil products. In particular, U.S. gasoline stocks are exceptionally low, and relief for the summer driving season is doubtful.
Energy-led inflation could also generate faster wage growth. The slowdown in pay gains in 1998-99 reflected, in some part, the energy-led drop in inflation in 1997-98. Back then, inflation expectations of workers fell as overall inflation was cut in half, to 1.6%. Companies could give real inflation-adjusted pay hikes even as nominal pay growth slowed. Now, that's set to reverse. With overall inflation heading back up, real wages will get squeezed and inflation expectations will rise, putting renewed upward pressure on nominal pay growth.
EVEN RAPID PRODUCTIVITY GROWTH may not be able to prevent inflation pressures this year. Greenspan is adjusting his productivity sermon to justify higher interest rates. He now says that, while stellar productivity continues to exert beneficial supply-side effects that restrain unit costs, it is also helping to fuel demand because it is lifting expected corporate returns and, thus, stock prices and household wealth.
Greenspan only hinted that this was a reason for higher interest rates, but the Fed's report that accompanied Greenspan's testimony was much more blunt. It said: "The boost to aggregate demand from the marked pickup in productivity growth implies that the level of interest rates needed to align demand with potential supply may have increased substantially."
To eliminate excess demand that wealth gains are generating, Greenspan is implying that stock prices will have to rise no faster than household income. Since the Fed began tightening last June, personal income has grown at an annual rate of 5.8%, while the broad Wilshire 5000 Stock Index, which the Fed appears to be focusing on, has risen at an annual rate of 14.9%. The three-month trend in the ratio of the Wilshire index to personal income continues to rise (chart).
Another problem facing the Fed is that the pickup in demand abroad compounds the difficulty of trying to slow U.S. demand. December exports surged 3.2% from November. Over the past six months, exports grew at a 17.8% annual rate, back to their rapid rate before the Asian crisis.
Greenspan summarized all these risks this way: "With foreign economies strengthening and labor markets already tight, how the current wealth effect is contained will determine whether the extraordinary expansion that it has helped foster can slow to a sustainable pace, without destabilizing the economy in the process." He didn't say how high rates need to go, but his hawkish tone strongly suggests that the risks to the economy are rising.