A reaccelerating national economy could lead to another one-quarter point federal rate hike when the Federal Open Market Committee meets on Oct. 5, coming on the heels of a similar quarter point hike on Aug. 24 hike. Reacting to several “economic imbalances” that had grown more acute during August, the Fed’s Open Market Committee (FOMC) tightened monetary policy on August 24. Rather than waiting until the October 5 meeting to take this action as we had expected, the FOMC acted more quickly, seconding June’s quarter-point hike in the funds rate with another quarter-point tightening, to 5 + percent. This induced the banks to hike the prime rate a like amount, to 8 + percent.
Further underscoring concerns about economic imbalances, the FOMC also acceded to requests of several Fed District Banks to increase the discount rate a quarter-point, to 4 + percent. The discount rate applies to lending by the Fed to financially troubled banks. Accordingly, it is set somewhat below the funds rate at which “healthy” banks lend reserves among themselves.
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So, the rise in the discount rate is of more symbolic significance during such healthy economic times as these. Moreover, it signals the intent of the Fed to maintain the higher level of the funds rate and may even suggest that the FOMC has a faction desiring even tighter policy.
Indeed, we now think a third rate rise is in the offing, even though the FOMC’s release stated that the tightening moves of June and August ” … and the firming conditions more generally in U.S. financial markets over recent months, should markedly diminish the risk of rising inflation going forward.” Neither should the FOMC’s announced continuation of its neutral bias for the period ahead deter them from increasing the funds rate another quarter-point at the FOMC meeting on October 5.
For one thing, June’s neutrality hardly prevented the August 24 tightening move. For another, there is ample evidence that the economy is reaccelerating this quarter. Signs of robust growth came with July retail sales, which shot up 0.7 percent last month on strong auto buying. This early reading on the current quarter points to a 3 + percent rise in real consumer spending, not that much slower than last quarter’s 4.6% revised rise and hardly a sufficient slowdown to placate the Fed’s intent to tighten.
The Fed has identified several “economic imbalances” that risk higher inflation and threaten the sustainability of economic growth. These imbalances include the tapped-out labor market that risks wage inflation, the lofty stock market that pushes consumer spending but could threaten the economy with a “correction,” spendthrift consumption that prevents economic slowing, the soaring trade deficit, and emergent Asian recoveries and related dollar weakness.
And latest indicators show “economic imbalances” have grown more acute since the Fed tightened monetary policy in late-June to preempt inflation. A serious inflationary threat came as private sector labor costs, including wages/salaries and benefits, posted the fastest gain in eight years, rising at an annualized 4.6 percent rate last quarter. Besides, employment growth continued quite strong through July, easing only slightly last month which still recorded a very low 4.2 percent rate of unemployment.
Adding insult to injury, not even housing has the decency to bow out under pressure from 7 + percent mortgage rates: Housing starts came roaring back in July, rising 5.6 percent above June’s one- month dip to a strong 1.66 million. Single-family dwellings rose rapidly as well, implying a longer period of elevated construction and related spending activity by consumers, lasting right on through this quarter.
So there is scant evidence that the economy is slowing sufficiently to satisfy the Fed. True, second quarter GDP growth did slow to 1.8 percent, less than half the pace of the first quarter. Yet that slowdown came from the big decline in our trade accounts and the rest from lower inventory investment. Had inventory investment held steady and the trade deficit not worsened, GDP growth would have exceeded 4 percent last quarter, close to the rapid pace actually realized by so-called “final sales to domestic purchasers.”
What is more, there is evidence that the decline in inventory investment was largely involuntary. This means that production and GDP actually will accelerate this quarter to rebuild inventories, especially for Y2K precautionary stockbuilding
Accordingly, in the face of tighter labor markets and even loftier stock prices, real GDP growth is likely speeding up toward 4 percent this quarter. This would handily exceed the speed limit deemed by the Fed to be safe for inflation protection. Next quarter should end the year with growth of about 3 percent. This would boost calendar 1999 GDP growth to 3.8 percent, hardly a slowdown from the 3.9 percent pace of last year. Besides, inflation will likely pick up this year, despite Fed tightening, with the CPI rate at 2 + percent across the year vs. 1 1/2 percent in 1998.
Another key risk to the inflation outlook has reappeared after retreating during May: Since June, crude oil prices again rose toward a two-year high this month. In the face of recovering world oil demand, and as long as oil-producing nations can continue to restrict production, crude prices will stay above $20/bbl., keeping petroleum product prices elevated. Indeed, late-July gasoline prices hit an 18-month high.
But recent levels of crude oil prices may be the peak for the time being, since OPEC and friends typically succumb to cheating on production limits when prices approach these heights. Accordingly, we think petroleum product prices will flatten and cease to be an inflationary problem.
The recent inflation gyrations in oil prices have been the only spoiler in our splendid record of low inflation. Indeed, the economy continues to purr along with price inflation largely absent: After struggling with higher crude oil and petroleum prices through April, overall prices for both producers (PPI) and consumers (CPI) have leveled off.
Accordingly, the Fed is turning its attention to “economic imbalances” in the U.S. that have become more acute since last fall, particularly in the last couple of months. With troubled foreign economies largely on the mend and with improved health in global financial markets, the Fed turns its attention this summer and fall to a U.S. economy that bounds ahead risking inflation and related imbalances.
Recall also that last year’s global problems sent investors fleeing to the safe harbor of U.S. Treasuries and financial markets. This had rallied U.S. Treasury bonds, sending yields downward through the end of last year. As foreign troubles eased, Treasury yields staged a bearish “yield rally” that did not relent until mid-August news of quiescent consumer and producer price inflation for July. This sent the 30-year Treasury yield back toward 6 percent after dallying near 6 + percent earlier in the month.
Bond and credit markets are suffering new imbalances of their own. It seems that credit and liquidity spreads are again widening, in some cases even more seriously than during last fall’s financial problems. Besides, interest rate swap spreads, another gauge of market risk aversion and illiquidity, have increased more than during last year’s financial problems.
Unlike last year’s episode when the widening in risk spreads took place in an overall declining trend for yields, the latest episode of higher spreads is occurring during a marked yield uptrend. This points up some new factors this time around, including the influence of the declining dollar, particularly vs. the yen and euro, and the record issuance of corporate debt relative to federal debt retirement.
Other factors likely contributing to the current widening of spreads include expectations of Fed tightening, consequent fears among bonds dealers about holding inventories, and concerns about the hemorrhaging U.S. trade deficit and related declines in the dollar. True, the widening trade deficit has served to offset strong domestic growth while affording stiff price competition that keeps inflation low.
However, the width of the deficit has itself become an issue. Sinking further in June to an horrendous $24.6 billion record, the merchandise trade balance looks headed to a record annual deficit exceeding $250 billion this year.
Some Pollyannas actually see a bright side to the trade deficit since it must approximate the amount of net foreign investment in U.S. markets for financial and real productive assets. They wrong-headedly explain away the negative personal saving rate, which hit a nadir of $70.7 billion last quarter, by praising this necessary inflow of foreign funds that the trade deficit represents.
But the bone of contention with the trade deficit, and the investment inflows it necessarily represents from foreigners, is not whether the markets (that equate saving and investment) clear. Like any unfettered market, they always clear!
Rather the real issue is “at what price” do the markets clear?
Really, there are two key prices, the yields on bonds and the dollar exchange rate. On both scores, the U.S. is paying the piper a very high price indeed for our spendthrift and import profligacy: both in the form of higher bond yields and a weakened currency.
Besides, unlike last fall when the Fed helped bail out the financial markets by easing, this time the resolution of spread widening will likely have to be a case of self-healing; more-so since the dollar is now falling vs. its rising trend last autumn.
Gary L. Ciminero is Economic Advisor, RI House Policy & Research Office
