M E R I D I A N     M A G A Z I N E

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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