Can the Fed hold the lid on interest rates? INFLATION FEARS
It's called the ``beige book,'' for the color of the cover. In the issue published March 17, the presidents of the 12 Federal Reserve banks across the country point to evidence that the national economy is improved and more steady. This improved economy was to be the subject matter of the Federal Reserve Board's Open Market Committee yesterday as it met to try to decide the future course of interest rates.
Fed-watchers believe the central bank will most likely ignore the ghost of inflation conjured up by a robust economy and will not force a significant rise in rates.
``The Fed is not likely to respond to [inflation] pressures yet,'' says Lyle Gramley, a former Federal Reserve governor.
But in the bond market, even the fact that the Fed considers the economy improved has pushed long-term interest rates nearly half a percentage point higher in the last two weeks. Last week, 30-year Treasury bonds yielded 8.68 percent, up from 8.25 percent two weeks ago.
``The bond market reacted worse than it should have,'' says Robert Brusca, chief economist at the Nikko Securities Company International. ``If there is not some problem out there, the market will invent a ghost,'' he adds.
Instead of dueling with concerns about inflation, economists say they believe the Fed will keep its eye on outside events. For example, some of the larger banks in the oil belt remain weak.
``The Fed is injecting more funds into the system so the Texas banks won't feel strapped,'' says Dan Seto, an economist with Nikko Securities. Only two weeks ago, the Federal Deposit Insurance Corporation lent nearly $1 billion to First Republic Bank in Dallas.
The weakness of the US dollar in the last several weeks, however, has constrained the Fed from loosening rates further. Differences between US interest rates and those of its trading partners are now considered quite narrow, says Steven Smith of Provident Capital Management in Philadelphia. As US interest rates fall, money flows to higher relative yields in Europe, pushing the dollar lower.
The dollar is hitting new lows compared to the British pound, the Canadian dollar, and the Australian dollar.
Although the dollar is also weak compared to the Japanese yen, Mr. Seto says some of this is seasonal - reflecting the end of the fiscal year for many Japanese companies, which are repatriating money earned by their foreign subsidiaries. When Japanese subsidiaries return funds to their parents, they have to sell foreign currencies and buy yen, which acts to strengthen the Japanese currency.
The declining dollar is nothing new for the Fed. Instead of becoming concerned about it, former Federal Reserve economist William Melton of IDS/American Express says the central bank will most likely want more information before it makes any moves.
``An old numbers cruncher like Alan Greenspan is going to want more data,'' he says.
This Friday, the Fed receives an important indication of the strength of the economy when the Labor Department releases the March employment numbers. In February, economists were surprised when the government reported employment grew by more than 500,000 workers. In March, 200,000 more people should become employed, a more reasonable growth rate, says Mr. Gramley, who is now chief economist at the Mortgage Bankers Association. ``If we're wrong, there will be rethinking by everyone,'' he predicts.
One indication the Fed is plugged in closely to these numbers is the ``beige book,'' in which Fed staff members have taken note of the tight labor conditions in many markets.
Economists are also watching the Commodity Research Bureau index closely. In the last two weeks it has shot up to new highs, reflecting inflation concerns. ``It's getting people nervous, too,'' says Mitchell Held, chief financial economist at Smith Barney.
Gramley says it is too early for inflation worries. ``As the economy gets stronger later in the year, it may raise questions of inflation in the second half, especially if growth exceeds expectations as it did in 1987.''
For the moment, however, the Fed is likely to sit tight. ``If we see anything, it will be very minor policy changes,'' predicts Mr. Brusca, a former Fed economist.