Fed Is On Track To Repeat Mistakes Of 1990
24 March 2000
Sun-Sentinel Ft. Lauderdale
(Copyright 2000 by the Sun-Sentinel)
For the first time during its record-breaking, nine-year expansion,
the U.S. economy faces a significant risk -- the Federal Reserve seems
intent on excessively raising interest rates.
The Fed, however, is misjudging the current economic climate and
overstating the potential for inflation. Because of the long lags
before monetary policy changes affect the economy, the Fed should gauge
the full effects of previous interest rate hikes before rushing to end
the expansion by announcing additional increases.
According to the Fed's illogic, the economy continues to grow too fast,
driven by the impact of rising stock prices on consumer spending. At a
time when labor markets are already extremely tight, rapid economic
growth will cause wages to accelerate, which will lead to higher prices
for consumers, the Fed alleges. The surge in oil prices supposedly will
also add inflationary pressure.
The Fed wants to reduce economic growth, which has averaged 4.5 percent
a year in recent years, to a non-inflationary level. The trend rate of
productivity growth has jumped to 2.5 percent, and the labor force is
growing by 1 percent annually. Thus, the economy can grow by 3.5
percent a year on a sustainable basis.
Despite the strong economic growth posted for the fourth quarter of
1999, emerging trends suggest that real growth in the U.S. gross
domestic product is beginning to slow.
First, with the exception of long-term bonds, interest rates have risen
by 150 basis points over the last 15 months. The yield on long- term
bonds has dropped sharply, which suggests that the bond market detects
slowing economic growth.
Rising interest rates are taming one source of the economic boom, the
housing sector. Builders are now reporting a decline in traffic at
building sites, and mortgage applications for new homes have dropped
sharply in recent weeks. The net impact of these forces will be to
reduce economic growth by about three-quarters of a percentage point.
Second, contrary to conventional wisdom, the sharp rise in oil prices
in recent months will have a deflationary effect on the economy. Unlike
the economic conditions during the oil shocks of the 1970s, the new
economy is driven by vastly different dynamics.
At present, intense competition prevents producers of most goods and
services from raising prices. Higher oil prices will create only a
one-time inflationary spike, with little risk of the wage-price spiral
that previously propelled inflation.
Furthermore, rising prices for gasoline and home heating oil will
squeeze purchasing power and slow the economy. The rise of $30 billion
to $40 billion in the cost of imported oil alone will reduce real
disposable income by more than 0.5 percent, with a corresponding
decline in household spending.
Third, the stock market's wealth effect is overstated. The evidence
indicates that consumer spending is driven more by wages and salaries.
Finally, concerns over tight labor markets emerged more than three
years ago, when the unemployment rate dropped below 6 percent. It now
stands at 4.1 percent. With vast shortages of workers, why have wages
remained relatively flat? Inflation fears are contradicted by recent
surveys indicating that most companies are not budgeting for sharp
increases in employee compensation.
The economic climate today resembles that of 1990, when the Fed kept
tightening while the economy was slowing, and when oil prices spiked
during the Gulf War. The result was the last recession before the
Monetary austerity is justified to combat inflation that threatens to
spiral upward. But absent inflation, why risk undermining the economic
expansion? The Fed should impose a moratorium on further tightening
until the economy feels the full impact of previous interest rate hikes
and rising oil prices.
Lawrence Chimerine is managing director and chief economist of the
Washington-based Economic Strategy Institute. Letters should be
addressed to Sally Heinemann, editorial director, Bridge News, 200
Vesey St., 28th Floor, New York, NY 10281.