FEDWATCH: BEHIND GREENSPAN'S PASS
The Fed's refusal Tuesday to engineer another cut in short-term rates is seen widely as indicating the central bank's general satisfaction with the current pace of economic activity. Last week, both Vice Chairman Alan Blinder and Gov. Larry Lindsey foreshadowed the outcome of this week's FOMC meeting, suggesting in separate press interviews that the central bank would be unlikely to cut rates in the absence of clear evidence of additional economic weakness. Lindsey told New York Times correspondent Keith Bradsher that the current environment is "exactly what the doctor ordered." Lindsey, apparently, has adopted a standard that would be difficult to miss, as his forecast calls for GDP expansion at a rate of 1.5% for the next year!
This extraordinary circumstance has until now gone virtually without comment. The popular press and most mainstream economists are in accordance with the Fed's apparent belief that the economy's current strength provides ample justification for maintaining a 5.75% funds rate. Yet, one Fed policy maker states for the record that his expectations are for "growth" that — for all practical purposes — is indistinguishable from no-growth. And he is happy about it! At the same time, the real federal funds rate is being held in a range historically associated with the risks attendant to the onset of, or recovery from, substantial inflation outbreaks. What's going on?
The only sectors of the real economy showing any significant strength are those most sensitive to the earlier interest rate declines, which have backed up considerably since early last month. Housing starts were up 6.5% in July, but industrial production, at a 0.1% gain for the month, is still below its level at year-end '94. Were it not for unusually hot summer weather ramping up electricity use, industrial production would have suffered its fifth consecutive monthly decline in July. Today's report of a 1.7% plunge in durable goods orders — as opposed to a consensus estimate of a 0.7% gain — gives additional weight to a disturbing trend. Durables have dropped in five of the past six months. With the exception of the red-hot market for electrical equipment (mostly computers and information technology), up 6.5% last month, durable manufacturing activity is sinking to near-recession levels.
Our assumption is that the Fed is not blind to the obvious. Assurances of steady growth may be fine for public consumption. The reality of the situation, however, leads us to suspect that the central bankers are giving a closer look to factors not yet widely in the domain of public awareness. Although monetary-aggregate watching has (thankfully) been out of favor for most of the past decade, there are indications that the behavior of broad money — particularly M2 — may be affecting Fed decision making, at least on the margin. In its report to Congress accompanying Chairman Alan Greenspan's Humphrey-Hawkins testimony last month, the Fed took the first — unnoticed — steps toward re-establishing a policy role for the aggregate: "The velocities of the monetary aggregates have been behaving more in line with historical patterns than was the case earlier in the decade....If M2 velocity continues on a more normal track, growth of M2 in the upper half of [its 1-5% target] range in 1995 and near the upper half of this range in 1996 would be consistent with the Committee's expectations for nominal income growth."
As it happens, M2 growth began accelerating early this year, and has been expanding at an annual rate of about 9% for the past two months, well outside the Fed's range. Although year-on-year growth remains low (under 3%), the recent trend could well be a caution sign to policymakers. Conventional models portray the aggregate responding primarily to changing opportunity costs. The flattening of the yield curve this year, according to this view, has drawn deposits into non-Mi M2 accounts (primarily money market funds and small time deposits) and out of longer-term instruments, which don't count as "money." The Fed, in other words, may be holding policy steady for now at least in part to confirm the recent steepening of the yield curve and thereby slow M2 growth. Of course, the belief that such privately created money could possibly become kindling for inflation reflects a demand-based orientation run amok. It holds that the buildup of M2 deposits represent assets which can be easily liquidated to fuel future spending, which could in turn create "excess aggregate demand."
This would be an ill-timed return to any sort of monetarist leanings at the Fed. From our perspective, the growth of M2 should be seen in parallel to this year's stock market rally. The equities markets are discounting higher future income streams, fueled in no small measure by expectations of capital gains relief. The wealth effects of the rally are boosting the creation of other financial assets and liabilities, the proceeds of part of which are showing up as M2.
While targeting a monetary aggregate at this point would be sheer folly, we do have some sympathy for Greenspan's predicament. It's clear that he would feel much better about things were the gold price closer to $350 than to $390. At the Humphrey-Hawkins hearings last month, he again spoke to the crucial role that gold plays in his thinking. In response to a query from freshman Rep. Jon Fox [R-PA], Greenspan asserted: "I do think there is a considerable amount of information about the nature of a domestic currency from observing its price in terms of gold....There is something out there that is terribly important that the gold price is telling us. I think that disregarding it is to fail to recognize certain crucial aspects of the value of currencies." Greenspan understands better than anyone at the Fed that the 10% increase in the gold price over the last two years is destined to show up in the price level if it is not reversed at some point. Thus he may be sympathetic to those who now argue for restricting growth to sub-optimal levels in order to forestall this eventuality. The Fed, however, is out of options for rolling back gold by strictly monetary means without inflicting substantial pain. That is why Greenspan would cheer as loud as anyone to see a capital gains tax cut, increasing the demand for dollar liquidity and moving gold back toward its equilibrium price.
Republican leaders in Congress and in the presidential lists are demanding that the First Lady should not go to Beijing for the UN conference on women. One foreign-policy"whiz kid who works for a GOP bigwig tells me almost breathlessly that it is "a lose-lose situation" for Hillary, whether she goes or does not go, depending on how she is viewed by American or Chinese women. This is all nonsense. Those few ordinary Americans who are paying attention these summer vacation days are happy enough to see a friendly gesture from the First Family to the people of China, with whom we are supposedly enjoying peacetime conditions. This is a prime example of Weathervane Bob Dole reacting to a right-wing Beltway breeze in order to determine his vision. The announcement from Beijing that it will punish human-rights activist Harry Wu by sending him back to the United States should cool things off a bit Better yet, House Speaker Newt Gingrich last night dispatched an aide to Beijing to sound out the leadership there on opportunities to improve relations between our two countries. Newt has taken to heart our criticism of his offhand China observations, as in "Newt in the China Shop," July 12, 1995. Thanks also to Henry Kissinger, who softened up Speaker Newt on China. I'm hoping that out of this, Beijing will return its ambassador to Washington and will accept the credentials of former Tennessee Sen. Jim Sasser, appointed ambassador to Beijing by President Clinton. Things are not as bad as they look.