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(03/24/00 - Chimerine) Fed Is On Track To Repeat Mistakes Of 1990

Fed Is On Track To Repeat Mistakes Of 1990
667 words
24 March 2000
Sun-Sentinel Ft. Lauderdale
Broward Metro
(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 current expansion.

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.

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