Opening a Window on the Fed’s Thinking


Whaddhesay? Federal Reserve Board Chairman Alan Greenspan testified Tuesday that economic growth will be slightly above 3% this year and inflation subdued at 3% or less. Still, interest rates will have to go up and folks should watch the price of gold and other commodities for signs of rising inflation.

What he didn’t say specifically is that short-term interest rates will probably rise to 4% by year-end, from 3.25% now, and that long-term rates, which influence mortgages, may go to 7% or so--from 6.6% at present.

Rate rises of that magnitude won’t stall the national economy, which is strong at the moment, although they may not do much good for California, which remains in the doldrums.


Still, California’s best hope is continued strength in the U.S. economy so it can take heart from Greenspan’s statement that “the outlook is the best we have seen in decades.”

And we can all take hints from his thinking on how the economy works, what lies ahead and why you may not get a raise but are more likely to have a job.

The Fed feels it must push up interest rates to prevent commodity prices from rising, such as those for copper, aluminum and steel that normally increase when industry and housing construction heat up.

The problem is not the price of metals but the effect of hikes in copper and aluminum on prices for food, cars and housing, the basics of the economy. If those prices increased sharply, employees would demand pay raises to keep up and serious inflation would occur for the first time in more than a decade. “Once inflation gets into wages, it’s very difficult to reverse,” says David Shulman, investment strategist for Salomon Brothers, who like most of Wall Street applauded Greenspan’s testimony to Congress.

Greenspan put an interesting perspective on Fed policy: “What we would like to foster and replicate are the periods in our past history where we have had considerable economic strength without inflationary imbalances occurring.” The last such period occurred in the late 1950s and early 1960s, the time of Presidents Eisenhower and Kennedy that is now looked back on as a golden age of prosperity and productivity.

Can Greenspan be right to compare this anxious age to that time? He can, but first we should remember that there was anxiety in that earlier era as well. There was a recession in 1958, and worries about America’s ability to keep up with a Soviet Union that had launched Sputnik; Kennedy got in a fight with business and the stock market swooned in 1962. But through it all there was productivity growth--more output for the same inputs of labor, material and investment--and thus low inflation.


And there is productivity growth today. Business is expanding now. Spending on plant and equipment is rising 15% a year, spurred by purchases of heavy industrial machinery as well as computers.

That’s good news because it confirms the economy’s long-term improvement. In the first stage of that improvement, over the last three years, U.S. industry has used cutbacks and downsizing to achieve increases in profits and productivity.

But gains from cutting staff could only take us so far, says economist Stephen Roach of Morgan Stanley. “The danger was that the world economy would pick up next year and U.S. business would be caught short,” says Roach. But now investment is expanding U.S. industry’s capacity to meet the demands of growing markets here and abroad.

Also, today’s business investment will prevent bottlenecks as the expansion continues. Already, skilled housing construction workers and truck drivers are in short supply in many parts of the country.

That’s why Greenspan is using interest rates as a throttle, to moderate growth. He wants to ensure that the economy can achieve growth and falling unemployment with price stability right through 1995.

And the fact that he’s thinking about 1995 is pertinent to California because that’s when most experts predict the state will rejoin the growth of the overall economy. Would lower interest rates today speed that recovery? Maybe and maybe not.


We should keep in mind that world markets, trading $1 trillion a day in securities and currencies, determine interest rates far more than the Fed these days. Any sign that the U.S. central bank was risking higher inflation to hold rates down would arouse global markets to drive up U.S. rates far faster than Greenspan is doing.

Those markets are already wary, as Greenspan said in taking note of the gold price and of investors’ “desire to hold hard objects rather than currencies.” All over the world, people invest in gold as a hedge against inflation. The Chinese are buying gold today because inflation is rising in China’s rapidly growing economy.

But concerns about more than China are involved in gold’s 16% rise to $378 an ounce from a low point of $326 an ounce last March 10. That surge reflects the markets’ wariness about Clinton Administration intentions and about budgetary effects of its health and economic policies. The markets may recall that the prosperous Eisenhower-Kennedy years were followed by the expansion of another government policy called the Vietnam War, which started the momentous inflation of the 1970s.

Are market fears justified today? Probably not. But in any case, an expanding U.S. economy based on business investment and productivity increases is the best response to their wariness. And that’s what Greenspan is trying to ensure with his cautious words and careful interest rate policies.