Fed May Be Poised to Ease, but for the Wrong Reasons

Nearly a quarter of a century ago, when it was becoming increasingly obvious that the United States was slowly sinking into the quagmire of Vietnam, Sen. George Aiken (R-Vt.) came up with an interesting idea that, if used at the time, might have saved many lives--not to mention millions of dollars. In a speech on the Senate floor in October, 1966, he said we should declare that we won the war and go home.

Today, a situation exists that calls for a similar recommendation. After years of Federal Reserve battling against inflation, it appears that the economy is in danger of sinking into recession.

Considering that the only inflation left is in services, because prices of most consumer goods are actually falling, Aiken’s suggestion seems to be applicable to Fed Chairman Alan Greenspan and his colleagues at the Fed: Declare victory over inflation, ease up on money and credit and let interest rates decline.

True, Greenspan acknowledged Thursday before the Senate Banking Committee that the Fed is poised to ease interest rates. But he said such a move--if it comes--would be in response to signs of a credit crunch among banks. Greenspan said he didn’t see any weakness in the economy that alone would justify easing rates.

Such a view flies in the face of considerable evidence.

An easier money policy would seem to be especially needed now, because it appears that there will be a tightening in fiscal policy related to a budgetary accommodation. The accommodation is more likely in view of President Bush’s willingness to accept a tax increase.

Fiscal policy aside, it is clear that the Fed has won the war against the portion of inflation it is capable of beating--prices of goods--and that it has done so at the expense of knocking the goods sector flat on its back.

Prices of goods that we consumers pay fell in April, compared to March, after the usual seasonal adjustments. And it fell again in May, compared to April. That means in the last three months, consumer-goods inflation has been stopped dead in its tracks.

If you want more evidence, look at the producer price index. Prices of raw materials, excluding food and energy, are actually down over the past 12 months; they’ve been falling year-over-year since fall, 1989. And prices of intermediate goods, the next stage of production, have been flat, year-over-year, since the beginning of 1990.

It’s not difficult to see why. Goods sales are falling. Retail sales declined three months in a row, before rising slightly in June, the first time that has happened since the last recession. Personal spending on goods very likely fell in the second quarter, compared to a year ago. Only twice in the past 45 years has such a drop not led to a recession.

Not surprisingly, goods payrolls are down, with the decline in the past three months one of the biggest for any three-month period since the last recession. And while fewer people are engaged in production of goods than 10 years ago, at the start of the 1980s, most of the recent downtrend reflects a slowdown in output as goods producers seek to avoid a costly buildup of unwanted inventories.

Construction is gasping for air. Home building is at its lowest rate since the recession--and a full 25% below the pace recorded 30 years ago. Meanwhile, business spending on structures is no higher today than 16 years ago.

Even export growth, the bright spot in the economy, is beginning to dim. After logging year-over-year gains of as much as 30% in early 1988, export growth has throttled back to less than 5%.

On the other hand, service prices continue to rise at an annual rate of 5%--the pace they’ve been clocked at since the beginning of the current expansion nearly eight years ago. Looking at the reasons why provides additional ammunition for those who feel that easier money is appropriate.

For one thing, services are labor-intensive. With unit labor costs climbing at least 5% a year in this sector, it’s hard for service industries to avoid raising prices.

The hikes tend to stick because, unlike many goods, services tend to be necessities. Consumers have little or no choice when it comes to paying the tab.

Two good examples are the cost of medical care and education. For nearly 30 years, medical services have been rising twice as fast as the consumer price index. In the past dozen years, the cost of education has ratcheted up 50% faster than the CPI.

It seems obvious that for doctors and hospitals to stop raising fees and for colleges to stop increasing tuition, the Fed would have to become so tight that the weakness in the goods sector would spread--and the entire economy would sink into recession.

Not that the Fed isn’t tight already. Bank reserves, the raw material that banks use to make loans and investments, have risen only 2% the past three years. This is the slowest 36-month rise since the three years ended February, 1958 (when the economy was in a recession), and compares to an average 36-month rise of nearly 15% the past 43 years.

The broadest measure of the money supply, M3, is growing at its slowest 12-month pace in 20 years. For their part, real interest rates (rates adjusted for inflation) remain well above what consumers and businesses can pay with comfort.

Corporate profits are tumbling because most businesses can’t raise prices enough to cover rising costs in a weak economy. As a consequence, profit margins are the lowest they’ve been since the last recession. And with dividend payouts historically high relative to after-tax earnings, most firms have little cash left to service their gigantic debt loads.

Since price-earnings ratios are already a third above average and interest rates are high enough to be drawing money into banks, any widespread cuts in dividends would seem to put stocks at risk of a substantial decline.

When Fed Chairman Greenspan was President Gerald R. Ford’s chief economic adviser, he started a campaign to Whip Inflation Now, and handed out WIN buttons.

Maybe it’s time for the Fed to realize it’s time to move from WIN to LOSE (Lift Our Sluggish Economy) so we can have a DRAW (Deliberate Recovery At Work).