Interest rates raised by stealth

The Sunday Times (London)

Monetary policy be stealth. That seems to be Federal Reserve Board Chairman Alan Greenspan's new technique as he maneuvers to keep all of his options open while he tries to gauge the future course of the American economy.

Greenspan has parlayed his masterful performances before various congressional committees into an increase in interest rates--without formally raising rates. The Washington rumor mill has it that the Chairman would like to follow last month's one-quarter of a percentage point increase to 5%, with another later this month, and perhaps still another before the year is out. But his colleagues on the Fed board are hesitant to go along, in the absence of some sign that inflation is making a reappearance on the American scene. Which it isn't, or at least hasn't yet.

But Greenspan used his testimony to let the markets know that he is nervous. Words like "shrunken pool of job-seekers", "strength of aggregate demand", "inflation risks" were capped by a promise to act quickly "should productivity fail to continue to accelerate and demand growth persist or strengthen". With words alone Greenspan sent interest rates up--rates on 30-year Treasury bonds pierced the 6% level and those on 30-year mortgages rose to a bit above 8%. And share prices down. No need for meetings of his policy committee, no need to take any real action to blow some of the froth off share prices. Monetary policy by stealth.

Greenspan has good reason to talk rates up. After his testimony, his twin fears were realized. The government reported that productivity in the second quarter of the year grew at annual rate of only 1.3%, a big drop from the first quarter figure of 3.6%, and below even the 2.2% longer-term annual rate that Goldman Sachs reckons has characterized the last four years. Note that Greenspan, who is famous for choosing his words carefully, says the he will raise interest rates "should productivity fail to continue to accelerate": mere maintenance of the recent productivity increases would not be enough to satisfy the Chairman.

He wants productivity to grow faster so that it will offset the wage increases that workers are starting to demand of staff-short employers. Ask any businessman, small or large, what his biggest problem is and you get the same answer: "I can't get staff." One reason sales of new homes slowed last month was that builders couldn't find enough construction workers to meet demand. Even unskilled service workers are in such short supply that hotels are offering to pay moving costs for maids, porters and other staff -- and to wink at the law requiring immigrants to have a "green card" in order to work legally in this country.

So when the government reported late last week that wages are starting to outstrip productivity gains, driving unit labour costs up by 3.8% in the second quarter, few observers who are in touch with real-world labour markets were surprised. They expect this trend to continue, forcing Greenspan to add to market pressures that are driving interest rates up.

There is worse, at least from an inflation-fighter's point of view. In addition to what may be a slowdown in productivity--always keeping in mind that one quarter doth not a trend make--we are seeing "demand growth persist", to use the words Greenspan spoke in laying his fears before Congress and, as he was well aware, the investors who hang on his every word. Consumer spending did ease a bit in the second quarter, but more recent figures suggest that growth may be picking up again. Factory orders rose 0.7% in June, following a 1% increase in May--the 10th increase in the last 13 months. And the National Association of Purchasing Management's index shows that activity rose still further in July. Also, department store sales are up, with Wal-Mart unsurprisingly leading the parade with a 9.6% jump in same-store sales in July. Sales at The Limited Inc. were up 6.8%, the Federated chain chalked up a gain of 4.7%, and the K-Mart, Dayton and Hudson chains all posted gains in excess of 3%. Not easy to do in July, since shelves were virtually picked clean by consumers in May and June.

Storekeepers are not alone in their joy. Housing sales are a bit below last year's torrid pace, but remain strong, as do auto sales. Ford sold more cars, sports utility vehicles and light trucks in June than at any time in its history. General Motors had its best month in more than ten years. Many models of Toyota's sports utility vehicles are in short supply. It now looks likely that auto sales this year will top the previous record, set in 1986.

What's more, there is every indication that the demand side of the economy will remain strong in the medium-term future. Consumer confidence is high, and the index of leading indicators is pointing upwards.

If that is not enough to make Greenspan see a rate increase in America's future, add rising commodity prices as the world's economies begin to recover from the Asian flu; a fall in the dollar, which will raise the price of imported goods; and second quarter corporate earnings that, in the words of The Wall Street Journal, "blew past analysts' estimates" and "won't weaken any time soon". So corporate spending on new plant and equipment is likely to remain strong.

Greenspan may find that America's Goldilocks economy is becoming a bit too hot for his taste, and decide to cool it. At least, that's what investors are starting to believe.