Trying
to Control the Economic Weather by Making the Economic Winds
by Richard
P. Halverson
This
article is a redrafting of an article I wrote eleven months ago.
Basically all that has changed in that time is the direction of
everything from the stock market to industrial production to the
level of employment and, very importantly, FED policy. I try to
illustrate the point of reversals by starting with the same article.
I use strikethroughs to delete words and [brackets
and italics] to add. Assuming the technique doesn't drive you
crazy I think you will find the juxtaposition between then and
now interesting.
The Federal Reserve Board (FED) arguably has more power over the economy than any other single entity in captivity. The FED has power to set certain interest rates that influence all interest rates. These in turn influence the values of stocks, bonds, real estate, commodities and many other elements of our economy. The FED has power to create money. This in turn influences the amount of capital available to buy and sell goods and services in the economy. The FED also has the power of the economic bully pulpit. This influences how business people, investors, consumers and politicians look at the economic future. Their goal is to keep the economy growing over time.
In the first article on the FED I ran through a simplistic explanation of the tools of the FED and how these tools work. If I did my job I probably left you with the impression that with these monetary tools the FED can "control" the economy. Unfortunately, they can't. They can influence it but they can not control it. The job is probably something like controlling the weather in Denver with a big fan on Pikes Peak.
In trying
to keep the economy growing over time the FED tries to steer an
economic course between too rapid growth that leads to inflation
and too slow growth that leads to recession. Steering the economy
in any direction is a very difficult job. First, it is hard to
know where the economy is at any point in time, and even harder
to know where it is headed. The measuring sticks are uncertain.
Second, the economy is uneven. It may be good for some sectors
and regions and bad for others. If you lose your job as
a mineworker in Hibbing Minnesota who cares that they can't get
enough computer programmers in Sunnyvale California.
[If you lose your job as a computer programmer in Sunnyvale
California who cares that they can't get enough mine workers in
Hibbing Minnesota?] Third, there is never any agreement on
how fast the economy should be growing. There will always be powerful
political forces wanting more or claiming what there is isn't
the right type of growth. The biggest problem, however, is that
the economy is really the sum total of the actions of hundreds
of millions of individual decision-makers all over the country
and even across the world. Consumers and business people all making
decisions on buying and selling. The FED has the ability to influence
these actions over time. It is a slow and uncertain process and
the FED is far from having the power to actually control all these
decision-makers.
For some months
now the FED has been concerned that the economy is growing too
fast [slow]. They are concerned this
rapid [slow] growth will lead to inflation
[recession]. They have been trying to arrest this problem
before it becomes serious. Here is a flavor of the difficult questions
the FED must struggle with and what they are trying to do.
1. Is the
economy really growing all that fast [slow]?
The current expansion began in June of 1991.
In terms of time this is the longest
peacetime expansion in history. As far as growth
goes this expansion is below average. Since June 1991 the economy
has experienced average quarterly growth of 3.49%. Average growth
during the past four economic expansions was 4.19%. [The
current slow down began in June of 2000. In terms of a slow down
this has been mild and has not yet begun to look like a recession.
Gross National Product (GNP) has not yet declined although other
important indicators have. In the last 3 quarters GNP adjusted
for inflation has averaged only 0.43%. Average declines during
the past four recessions were -2.1%.]
On-the-other-hand,
things are still picking [slowing] up.
Growth in the last year was 4.93%. The FED believes the
current rate of growth is too high. They believe this growth will
cause everything from oil to labor to fall into short supply and
result in higher prices. [While the past expansion
did cause everything from oil to labor to fall into short supply
production has been falling and unemployment is now rising.]
The FED does not announce their comfort zone for growth but I
am sure it is lower [higher] than where
it is.
2. Unemployment
is at a 40 year low of 4.0%. [Unemployment has increased
to 4.5% in recent months.] The fear is [was]
that a tight labor market will [would]
result in higher labor costs that will [would]
result in inflation. Most people have seen many anecdotal
evidences of the tight labor markets. Fast food companies are
spending as much time advertising for workers as they are for
hamburgers, people piracy is common and fat signing bonuses are
being paid even to entry level workers. [Many of
the anecdotal evidences of the tight labor markets are disappearing.
Help wanted signs are coming down, articles about layoffs are
in the paper daily, recent graduates are finding it harder to
land jobs and fat signing bonuses are history.]
On-the-other-hand,
employment costs have only risen about 3.3% a year during
this expansion [been rising more rapidly in recent
months. They have increased 4.2% in the last two years and recorded
the largest quarterly gain in a decade last quarter.] This
compares to annual increases of over 5.0% during the 1980's and
double that during much of the 1970's. [In recent quarters
productivity has become much more sluggish and has been negative
in the manufacturing sector.] Technology has allowed companies
to pay workers more but get higher productivity. In this cycle
that is particularly true in the huge service sector. More people
work in the service sector than in any other sector of the US
economy. In previous cycles productivity gains have come mostly
in areas like manufacturing where bigger and faster machines could
crank out products with lower cost. The service sector, however,
is labor intensive. For years economists believed little could
be done to substantially improve productivity in the service sector.
(They might know, economists are in the service sector and few
people would consider them productive.) However the economists
were wrong. (What a shock!) Personal computers have changed things.
Innovations from e-mail to spell checkers, from laptops to cell
phones have resulted in tremendous productivity gains in the service
sector. (Even economists are cranking out more predictions faster
than ever with the same amount of effort. Now there's real productivity.)
Hey, I am sort of an economist myself, so I can say these things.
In addition
to productivity gains worker pay demands have thus far
[had] been mild. This is [was]
a surprise. Despite the tight labor market, surveys continue
to indicate workers are afraid of being downsized and laid-off.
The result? Workers have been less aggressive in their wage demands
than might be expected at 4.0% unemployment. [Despite
rising unemployment workers demands have been increasing. Strikes
or threatened strikes have popped up everywhere from airlines
to nursing.] And companies have been able to offset
much of the [are finding increasingly difficult to
offset] higher wage costs with productivity.
3. When the economy expands rapidly the price of commodities usually rises sharply. Commodities include things like copper, oil, timber, sheet rock, steel, etc. It is a classic matter of supply and demand.
On-the-other-hand the Commodity Research Bureau's index of commodity prices is essentially flat during this entire expansion. In fact, current levels are approximately 30% below where they were 20 years ago. The reasons for this are complex but they have to do with the shortages and the huge inflation bubble of the 1970's followed by a period of over production, conservation and productivity improvements that continues today. [The index did rise during 2000 to 230 in November and has since fallen to 210.]
4. When
asset values reach speculative levels consumers feel a sense of
unwarranted wealth and then spend aggressively. [When
asset values plummet consumers feel an unwarranted sense of poverty
and save aggressively.] Stocks are the asset of concern in
this cycle. In other cycles it has been real estate, gold or other
asset. Of particular concern is how many people own stocks and
are afflicted with this euphoric [depressed]
feeling of wealth [poverty]. With the
rapid expansion of 401k's, stock options, and mutual funds stocks
are more widely held than ever. I know that sounds like a good
thing and it is, unless it tricks people into thinking they are
better [worse] off than they are. Many
people are enjoying [have seen] large
paper profits [evaporate]. Even though they often
can [were] not able to spend the paper profits
there is a feeling of [lost] wealth that encourages
[discourages] the consumer to spend more of his/her
current income and take on more debt [and causes
them to avoid] spending. Not only does this artificially
hype [depress] the economy it is risky.
The markets can and do [did] drop in
value. Paper profits can shrink rapidly [have
shrunk]. [In many sectors] if the
psychology of optimism [has] changed to panic with the
speed of a market plunge and many people will get
[have been] hurt.
On-the-other-hand
with all the fundamentals looking solid [weak]
and new technology fueling the advance [corporate
profits declining] the market looks resilient
[dismal]. Many experts believe stocks will double
or triple during the current decade [fall much further].
They fear the major risk to the market is an over
[under] reaction by the FED.
The list of
worries and on-the-other-hands the FED is wrestling with is almost
infinite. At this point of this [even after]
the long economic cycle inflation is still amazingly tame. In
fact, this is one of the most frightening on-the-other-hands.
With so little inflation in such [after such]
a strong economy are we on the verge of deflation? There is not
space to get into it here but deflation is worse than inflation.
And there are few to no proven ways to fight a deflation -- except
war. I think we will all agree war is a lousy alternative to good
economic policy.
Because
inflation is tame many politicians and economists argue the FED
should not be trying to fix something that is not yet broken.
To continue torturing cliches I guess the FED has decided that
a stitch in time is worth nine. This is true. If there is going
to be an inflation problem the FED is certainly correct to act
preemptively. Once prices start rising and inflation psychology
gets embedded it is very tough to stop.
[Because unemployment is rising many politicians and economist argue the FED is not acting aggressively enough to fix something that isn't yet clearly broken. If there is going to be a recession the FED needs to act preemptively. Once recessionary psychology gets embedded it is very tough to stop.]
Here is what
the FED has been doing to slow [speed-up]
the economy and fight inflation [recession.]
•The
economic bully pulpit. The FED has been trying to talk
the stock and bond markets down. The market pays attention to
what the FED Governors say so this can be a potent weapon. There
are several things the FED hopes to accomplish by this. Perhaps
the most important is to reduce speculative fever in stocks which
can fuel the market and the economy for awhile but is then followed
by a plunge and possible recession. In December 1996 Alan Greenspan,
the most listened to person in the world on the economy, gave
his famous speech where he said the stock market was "irrationally
exuberant". Stocks dropped liked punctured balloons for a few
days. Then they started rising again. Despite this and other verbal
warnings from the FED the S&P 500 is up about 96% and the
Nasdaq is up an astonishing 200% since then. [The
FED is not trying to talk the market up but they are no longer
talking trying to talk it down. Further, Board members have made
statements expressing concern about the negative effects of wealth
implosion. From its peak of 5048 the NASDAQ dropped 3410, over
-67% of its value, in 13 months. It has since recovered over 500
points. The S&P 500, which measures larger stocks did not
decline as much. It fell -28% and has since recovered about 36%
of what it lost.]
•Raising
[Lowering] rates. In June 1999 [December
2000], after fair warning [with little
warning] I might add, the FED began raising
[dropping] the Fed Funds Rate [aggressively].
Through this they hope to see all interest rates rise
[fall]. When money gets more [less]
expensive fewer [more] people can afford
to borrow. In theory not only should interest rates rise
[fall] bonds should fall [rise]
in value. Further, higher [lower] rates
should mean fewer [more] people can
afford to borrow to buy homes, cars and new computer factories.
Remember the FED only has authority to set a few rates not all
of them. The idea is these will influence others which are set
by the free market.
Results have
been mixed. The prime-lending rate charged by banks to their best
customers has risen [dropped] from 7.75%
to 9.50% [9.50% to 7.00%]. A company borrowing
$1,000,000 is now paying $17,500 more [$25,000
less] in interest cost than before. Still commercial borrowing
is at record highs [falling]. Mortgage
rates have risen [dropped] from 6.86%
to 8.10% [8.33% to 6.79%]. This means the monthly
payment on a $100,000 mortgage has risen [dropped]
from $656 to $740 [$757 to $651] a month.
The result is some people will not get approved
for their dream home. Others will have to settle for a
cheaper dream [can dream a little more than they
thought]. Rising [Falling] interest
rates effect many homeowners that are already in their house.
Many homes are financed with adjustable rate mortgages. As interest
rates rise [fall] so do their monthly
mortgage payments. This can come as a real shock
[boost] to a household budget. Rising
[Falling] mortgage rates do seem to be slowing
[increasing] housing. New housing starts are about
where they were last summer [up nearly 9% since their
lows last year]. Rates for auto loans, personal loans and
credit cards have all been effected. Thus far none of these areas
show great weakness [strength].
The effect
of the FED rate increases [decreases]
that began last summer [winter] seems
to have been lost on the stock market. The S&P 500 is up
6.9% [down -5.3%] and the Nasdaq is up
48.7% [down -17.7%] since the first rate increase
[decrease]. And amazingly enough even some interest rates
are not cooperating. For example, the current yield on the 30-year
Government Bond has actually fallen [risen]
from 6.00% to 5.80% [5.44% to 5.73%].
•One
of the FED's most important powers is its ability to influence
money supply. The measure of money referred to as M1 rose
sharply during the winter of 1999. It is almost certain the FED
ran the money supply up due to Y2K fears. That spike makes it
difficult to figure out exactly what they are [were]
doing. Since December1999 basic money supply has been trending
down. However, it still shows an increase over a year ago. Perhaps
a better measure is the broad M3 money supply statistic. It includes
many things beyond currency and checking accounts. In the end
the economy probably better with M3 than M1. The FED can not control
M3 directly; it can only influence it. It shows only the slightest
hint of slowing in its rate of growth. There are two points. First,
the FED has not yet chosen to fight inflation by aggressively
shrinking the money supply. Second, even what they may have done
has not filtered out to the broader measures of money supply.
[After a period of slow growth in the second half of 2000
for all measures of money the increases have picked up sharply
in the first half of 2001.]
Why have the FED's results been so mixed? It takes time for these measures to work. Can you imagine how much wind you have to blow off Pikes Peak to change the weather in Denver? Economic inertia is amazing. Remember the economy is really the product of billions of decisions made by hundreds of millions of individuals every year. If you've been planning for years to build a home and now you've started you do not quit just because mortgage rates go up. If you have been dreaming about a new car you buy it even if the financing is more than you expected. If a company has been planning a new office for five years they build it even if the prime rate is up. [If the home you just built is costing you more than you planned because mortgage rates were so high and you are worried about your job, you postpone the furniture. If you bought a car and the monthly payments are high you postpone taking a trip. If a company borrowed heavily to build a new office but is now laying-off workers they postpone building a new factory.]
Results may
be mixed thus far but do not bet against the FED they can pump
out a lot of wind. Inertia may be dragging this out but you can
bet the FED will the eventually succeed in slowing-down
[speeding-up] the economy. Their actions chip
away at the edges [fill in the cracks]. Eventually,
the upward [downward] inertia slows
[improves]. When that occurs is the time for anxiety.
The FED always wants a so-called "soft landing". A slowing in
the rate of growth, not a decline. There never has been a true
soft landing. By the time the pressure to slow things down becomes
measurable in the statistics the slowing forces are already deeply
embedded enough to cause the economic pendulum to swing the other
way. At least a mild recession is a fair bet. A mild recession
will probably mean unemployment rising from 4.0% to 4.5 to 5.0%
(which is an all out depression if you happen to be part of this
statistic). Gross National Product will probably decline for 3
to 6 months early next year. Corporate profits will be effected
on the downside. Today's stock market is still counting on a soft
landing. If FED action over shoots and pushes us into a mild recession
it will effect the stock market. In fact the stock market will
tell you what is going to happen to the economy. If it declines
in the fourth quarter it is probably signaling a mild recession
in the first quarter of 2001. If you see that phenomenon develop
you may want to worry about your income and debt load instead
of worrying about your stocks. [It is too early to know whether
last year's actions will eventually produce a "hard" or "soft-landing".
If things begin to improve from here the FED will have succeeded
creating a "soft-landing". However, if the FED's recent stimulus
proves too much, too soon the risk of serious inflation becomes
a problem.]
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