U.S.: Putting On The Brakes Without Crushing The Dollar

But more tightening could limit small-business borrowing

Just days after the Federal Reserve intensified its battle against inflation, economists got the first sign that the Fed's past assaults have started to hit their target. Banks are getting more cautious in their lending decisions. That's a key step toward tightening overall financial conditions in this economy.

But how restrictive will conditions need to get to slow demand and fend off rising cost pressures? After all, we're talking about an expansion where equity gains have pumped up household wealth tremendously, where demand is excessively strong, and where labor markets are stretched as thin as phyllo dough.

All told, the outlook for inflation carries more risks this year than it has in a long while. Economists are already lifting their inflation forecasts for 2000 to the 3% range, from the mid-2's just a few months earlier. Little wonder, then, that policymakers may prefer pursuing a bolder policy stance to the risks of falling behind the inflation curve.

Moreover, that strategy may become more urgent later on this year or early next if the Fed were to lose one of its most successful inflation-fighting allies: a strong dollar. The foreign trade deficit continues to soar to levels unthinkable a year ago. Amid a mountain of U.S. foreign obligations, the dollar will become increasingly vulnerable, especially if Fed tightening hits the economy harder than now expected. A weaker dollar would boost import prices, removing a key offset to rising domestic prices.

OF COURSE, changes in monetary policy work with a time lag. You could argue the Fed's first three rate hikes, from June to November, were just takebacks from the easing of 1998, so that the Fed didn't really begin to tighten until this January. Even so, Fed officials had to welcome the news that banks are now raising the bar on their lending standards (chart).

The Fed's own Senior Loan Officers Survey showed an "intensification" in the recent trend toward firmer lending practices. The report said that in the second quarter 24.6% of banks tightened requirements for midsize and large companies, and 21.4% are more restrictive for small-business loans. Excluding a spike during the autumn 1998 financial turmoil, lending practices are the tightest in a decade.

In addition, banks, in general, have increased their rate spreads on business loans, and they are slightly less willing to extend credit for many consumer loans. At the same time, however, banks have loosened up lending for residential mortgages compared with two years ago. In particular, banks are more willing to increase the size of a mortgage, perhaps reflecting that the hot housing market is pumping up home prices.

The loan survey highlights a fresh twist in monetary policy. Thanks to the variety of credit instruments now available to borrowers, small business may well be the Fed's new whipping boy. That's because bank lending is typically the main source of financing for the small-biz sector. Larger companies can borrow in the debt market; e-commerce enterprises can tap venture capital. So if the Fed must turn the screws tighter--as seems likely--look for small companies to get caught in the vise.

Indeed, with the Fed's past hikes still making their way through the financial system, bank lending is likely to grow more restrictive. But for now, policymakers are unwilling to wait and see. Although the loan officers' survey was released on May 19, policymakers already had the information on May 16, when they raised short-term interest rates a large half-point.

THAT AGGRESSIVE MOVE was likely prompted by the economy's continued signs of strong demand. The latest evidence of that momentum came from a further deterioration in the trade deficit. The monthly trade gap for goods and services crossed the $30 billion mark in March, hitting a record $30.2 billion. Reflecting heavy demand both at home and abroad, exports posted a large 2.9% gain for the month, and imports also advanced a sizable 3.4% (chart).

March exports, led by electrical and telecommunications equipment, autos, and industrial materials, were especially strong, considering the sharp 49% dropoff in foreign shipments of aircraft as a result of the strike at Boeing Co. Aircraft exports plunged to $835 million in March, after averaging $2.4 billion per month last year. With the strike now settled, shipments will rebound up toward that level in the second quarter, adding further strength to overall exports.

Recovering economies around the globe, especially in Asia and Latin America, are boosting U.S. exports (chart). This time last year, shipments to all Pacific Rim countries were dead in the water compared with their year-earlier levels. But in March, they were up 20% from a year ago. Exports to Mexico and South America this time last year were down 9.5%. Now, their yearly growth rate has soared to 29%. Exports to Europe should also pick up further in the coming year, as the recovery in the euro zone gains speed.

DESPITE BUILDING EXPORT STRENGTH, any improvement in the trade balance will be severely limited by the surge of imports. The March gain only partly reflected the month's climb in oil prices to a nine-year high. Excluding oil, imports still rose 2.5%, as autos and consumer goods posted sharp increases.

The problem is that imports have now grown to a level that is about 30% greater than exports, up from a 20% differential a year ago, and from a 12% gap only two years ago. That means that the growth rate of exports now has to be 30% faster than the pace of imports just to keep the trade deficit from widening further. Consider that over the past year, imports have increased 21.9%, while exports are up only 13.4%. At the current pace of imports, exports would have to grow 28.5% just to hold the monthly gap at $30 billion.

U.S.: Putting on the Brakes without Crushing the Dollar
U.S.: Putting on the Brakes without Crushing the Dollar
U.S.: Putting on the Brakes without Crushing the Dollar

Because of the rapidly growing financing costs associated with this year's widening trade gap, the broad U.S. current-account deficit--which includes trade in goods and services and net payouts of investment income to foreigners for the use of their capital--is very likely to hit a record 5% of gross domestic product by the end of the year. That huge dependence on foreign capital could make the dollar vulnerable, should the investment climate in the U.S. become less favorable. However, without a significant slowdown in U.S. demand, imports will continue to soar, and the current-account gap will only balloon further in 2001.

That leaves the Fed with a problem of timing. Policymakers want growth to slow soon enough to ease price pressures at home, but not so quickly that foreign investors are scared off and send the dollar crashing. Achieving the right balance will be a delicate maneuver. The Fed may have drawn first blood, but the tricky battle to cool off this economy is far from won.

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