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INTEREST RATE WATCH
Prepared by
R.J. O'Brien & Associates, Inc.
Federal Reserve
There is a strong likelihood of wage pressures ahead, and inflation may rise, unless there is a marked slowing in demand for goods and services. Alan Greenspan (10/8/97)
Inflation has stayed low and is even falling, despite an ever tighter labor market. We are not using the Labor Department's Employment Cost Index as a signal of future inflation. The link between wages and inflation is unclear. It's not clear that wages cause inflation or whether inflation leads to accelerating wages. Alan Greenspan (this week)
When approximately six weeks ago we began writing about an apparent “sea change” in investor attitudes in stocks and the dollar, we didn't know that the sea change would turn into a world-wide tidal wave. The carnage in currencies has spread to the world stock markets. and it is now widely accepted that the Federal Reserve cannot and will not act to raise interest rates. Indeed, many respected economists are talking about the danger of deflation. and the market is now beginning to price in an “inevitable” Fed ease. In his Congressional testimony, Mr. Greenspan readily dismissed the deflation talk, but he admitted that the stock market decline could have a “salutary effect.” It's obvious he now believes that the currency turmoil and declining stock prices will lower the demand for U.S. goods and services, thereby obviating the need to raise short- term interest rates.
We think it's too early to quantify the effect that the Asian problems will have on our economic growth (Mr. Greenspan safely predicted it would have a moderate effect, but it wouldn't be negligible). The danger is that by delaying the need for higher interest rates, the Federal Reserve will be “falling behind the curve of inflation.” We think the world wide debacle in stocks and currencies is forcing the Fed into a box into which there is no easy escape. Our reasoning follows.
One, U.S. wages are accelerating. The evidence is so overwhelming that even the biggest bull can't deny it. This week, the government released its Employment Cost Index. its broadest measure of U.S. wage and salary growth. It spurted to a 3.5% yearly growth rate, the highest in over five years. Backing this up was the Treasury's monthly budget statement. Individual income taxes paid in September were 13.87% higher than the same month a year ago. Tax returns are the “hardest” possible evidence of consumer income growth, and double-digit increases in tax payments suggest that the government's measures of income growth are absurdly low.
It was just a few weeks ago that Mr. Greenspan said: “to believe that wage pressures will not intensify as the group of people who are not working, but who would like to, rapidly diminishes, strains credibility. The law of supply and demand has not been repealed. The performance of the labor markets this year already suggests the U.S. economy has been on an unsustainable track.” The currency and stock debacle now forces Mr. Greenspan to say that “It's not clear that wages cause inflation or whether inflation leads to accelerating wages.” We think he's splitting hairs. It doesn't matter which causes what. The higher income growth now so evident will give consumers the ability to pay higher prices for U.S. goods and services.
The prospect is for accelerating wage growth. Thursday's unemployment claims were the lowest in three months, and the Conference Board reported an increase in its Help Wanted Index. It's obvious that the demand for labor is increasing at a time when the supply of labor is decreasing. It was important a few weeks ago, and it's important now.
Two, the dollar is failing. In the FOMC minutes for the August 19th meeting, the Federal Reserve noted that several factors, including the strong dollar, “contributed to keeping inflation at bay, but possibly only temporarily.” However, as we have noted several times in the last six weeks, the trade weighted dollar index has been declining, and it is now approximately 6% below the highs made on August 6th. The weaker dollar has occurred despite the fact that the dollar has gained substantially against most Asian and South American currencies. Why are investors preferring European currencies at a time when the U.S. economy is enjoying excellent growth with low inflation and while European economies are plagued by low growth and high unemployment? More pointedly, why has the Japanese Yen gained against the dollar in the midst of an Asian currency freefall? As Mr. Greenspan noted this week, if any country will be hurt by the trouble in Asia, it has to be Japan. We have a few explanations, and none of them are good for the U.S. credit markets.
One reason for the recent Japanese currency strength could be that Japanese banks, now troubled by declining property values throughout all of Asia, are selling U.S. Treasuries and bringing their money back home. We don't know who is doing the selling, but we do know that in the week ending October 29th, foreigners liquidated $7.5 billion of U.S. debt, making it a total of more than $15 billion sold in the latest two-week period. So far that additional supply has been more than offset by purchases from scared U.S. stock market investors, but it should be remembered that foreigners own close to 30% of the huge U.S. public debt. A weaker dollar will at the least discourage new foreign purchases and could lead to additional liquidation of massive foreign holdings.
One explanation for the strength in European currencies is that investors are afraid the Federal Reserve will back off from its inflation fight. As we have noted in previous reports, U.S. monetary growth has been torrid, with M2 and M3 growing at a 6.1 % and a 9.0% rate over the last thirteen weeks. If the stock market and currency woes continue, and the Fed is forced to supply additional liquidity to U.S. and foreign economies, the additional boost in monetary growth could prove inflationary. A further rise in the supply of money should lead to a decrease in the price of that money. In other words, a falling dollar and higher short-term rates.
Three, the Fed believes that real short-term interests rates are not restrictive. Mr. Greenspan said it himself: “if real rates were perceived as severely restrictive, you would see housing and motor vehicles showing signs of contraction. We don't see that at this particular time. Also the money supply growth has been somewhat stronger than we projected, which suggests there is no particular restraint going on in the banking system. Moreover, in the fed senior loan officer survey, we don't pick up any significant degree of restraint there either.”
If rates are not restrictive, there is no need for the Fed to ease. The economy is extremely strong, and the U.S. consumer, whose spending fuels two-thirds of GDP, is in excellent financial condition. His income is rising rapidly: his home's value has risen by more than 7% over last year, and despite this week's stock debacle, his stocks are up 30% over year ago levels. That's why Mr. Greenspan hopes the stock and currency decline will prove “salutary,” he's hoping it will keep the U.S. economy from overheating.
November 1, 1997R. J. O'Brien & Associates, Inc.
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Copyright 1997, by Consensus Inc. All American and Pan American rights Reserved. editor@consensus-inc.com
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