Fed's Attempt to Nip Inflation Signals Move to Restrain Economy
Alan Greenspan is sending a message: He won't let the economy get too rambunctious in 1994.
The message from Mr. Greenspan, the chairman of the Federal Reserve Board, is in the form of higher, short-term interest rates, starting last Friday, when those rates rose about one-quarter of a percentage point.
Greenspan, in an unusual departure from Fed policy, issued a statement that said he made the preemptive move ``in order to sustain and enhance the economic expansion.''
Normally, the Fed does not immediately comment on its monetary policy shifts.
Greenspan's concern is that the US economy is too robust, and this could result in higher inflation rates later in the year.
``It's kind of like parking your car on the railroad tracks - you can leave it there when there is no train coming but by the time the train comes it's a disaster,'' says Charles Plosser, dean of the William E. Simon School of Business Administration in Rochester, N.Y.
Although Greenspan had indicated earlier last week that this turn in interest rates - the first uptick since 1989 - was likely to happen soon, investors acted with dismay. On Friday, the Dow Jones Industrial Average plunged 96.24 points, the worst loss in two years. The worst-hit stocks were interest-sensitive issues such as banks, which benefit from falling interest rates.
Economists believe it is likely the upturn is just the beginning of a slow rise in rates this year. ``If I am any judge, this is just the first in a series of tightening measures this year,'' says Lyle Gramley, chief economist at the Mortgage Bankers Association and a former Fed governor. Mr. Gramley expects the Fed funds rate -
the rate at which banks lend each other money overnight - to reach 4 1/2 percent by year-end, compared with 3 1/4 percent on Friday.
The purpose of the rate hikes will be to slow the economy down.
Economist Mickey Levy of NationsBank believes the economy is currently growing at about 4 percent per year. He points out, however, that there are parts of the economy that are spurting ahead at a much faster pace.
Areas of quick growth
``The curve on durable goods orders has shot straight up,'' says Gramley, who notes that businesses are optimistically placing orders for equipment to increase production. ``Capital goods orders are up over 50 percent in the fourth quarter,'' he adds.
According to a survey of purchasing executives, the economic growth continued last month. The National Association of Purchasing Management reported last week that new orders for January increased at their highest rate since December 1983. Backlogs grew sharply in January as manufacturers could not keep up with the order pace and even exports shot up - to their highest level since 1991.
This heightened economic activity is likely to start to show up in the inflation rate.
On this coming Friday the government reports the January inflation numbers. Economists at Merrill Lynch & Co. predict the producer price index will rise by 0.4 percent, compared with a drop of 0.1 percent in December. However, they expect the consumer price index to rise by only 0.2 percent, the same increase as in December.
The Fed's actions on Friday will have only a minimal immediate effect on the economy. Variable rate mortgages, which are usually tied to short-term rates, should rise slightly. Investors holding certificates of deposit and money market funds will get a slightly better return. Even though 30-year Treasury yields rose from 6.30 percent to 6.35 percent, it is not likely to result in an immediate rise in fixed rate mortgages.
However, economist expect that as the Fed tightens rates during the year, the effect will be to slow growth. By the second half, Gramley predicts the economy will be growing at a 3- to 3 1/2 percent rate, down from 4 percent now.
Timing of move
One of the reasons for the sharp drop in the stock market was the timing of the Fed's move. On Friday morning, the government reported the January unemployment rate had risen to 6.7 percent compared with 6.4 percent in December.
However, this rise was the result of a change in the calculation methodology so the government could get a more accurate idea of female unemployment. Under the old system, the unemployment rate would have been 6.3 percent.
Although the unemployment rate would have dropped, investors focused on job growth, which was a scant 62,000. This slow job growth is partially the result of the extremely cold and snowy winter. ``It is hard to explain and understand that when you have the weakest employment report in five months that is good enough for the Fed to raise rates,'' says Robert Brusca, chief economist at Nikko Securities International Limited, Inc. in New York. Mr. Brusca notes that many traders felt it was safe to buy bonds on the basis of the employment report - ``and then the Fed sucker-punches them.''
However, the Fed may have also wanted to get the rate rise out of the way before the US Treasury tries to sell about $40 billion in securities this week.
``It's probably better now than when the Street is heavy with $40 billion in securities,'' says Brusca.
Although the rate rise will cost the US government more money, Treasury Secretary Lloyd Bentsen told reporters on Friday that the rate rise was already figured in the government's budget forecasts.
The budget, due to be released today, estimates short term rates will rise by half a percentage point in 1994.