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INSIDE THE FED

It was mid-April. Financial markets were only just recovering from the carnage unleashed by two quick Federal Reserve interest-rate hikes. Bond yields had been driven up a full percentage point. The Dow Jones industrial average was down 306 points. And White House economic coordinator Robert E. Rubin was worried. Fed Chairman Alan Greenspan, however, was adamant. Brace yourself, Greenspan warned Rubin, more tough monetary medicine is on its way.

Greenspan was as good as his word. In an Apr. 18 conference call, Fed policymakers agreed to implement the next phase of a plan that had been hatched 10 weeks earlier. To move monetary policy from stimulative to "neutral," the Fed would nudge short rates up a quarter point a month until reaching some unspecified target. For Greenspan & Co., keeping the economy from overheating was more important than calming traders' nerves.

Rather than inspiring confidence, though, the Fed's latest maneuver jolted financial markets even more. Congressional Democrats grumbled. And business executives have begun to wonder if an overzealous central bank is comfortable only with an anemic economic pace. The Fed "should leave well enough alone," fumes Ralph A. Beattie, chief financial officer of Haggar Corp., the Dallas clothesmaker. "They're trying to fix a problem that most people don't see as very serious."

MIXED SIGNALS. The jitters are justifiable. Greenspan's public signals have been confusing, in part reflecting an ever more complicated global economy. Steering monetary policy has become more perilous than ever. The natural question: Just what's going on inside the Fed?

Plenty. Greenspan and his colleagues face unprecedented challenges to their ability to manage the economy. The explosive growth of exotic financial instruments has weakened the central bank's ability to control the growth of money supply. Traditional early-warning signals may no longer work to detect the onset of inflation. Even though capacity utilization is rising and U.S. labor markets are tightening, for example, the ability of American companies to shift production offshore may mean that inflation is less of an imminent threat than statistics suggest.

Volatile global markets, meanwhile, mean that a small Fed action can be magnified into a nasty worldwide jolt. "The markets don't have a clue what the Fed's doing, and the uncertainty has driven up long rates," says Allen Sinai, chief economist of Lehman Brothers Global Economics.

The jitters have been heightened by the prospect of personnel shifts within the Fed: Two empty chairs have given President Clinton the opportunity to impose his imprint on the nation's central bank. He will name Council of Economic Advisers Member Alan S. Blinder to the bank's vacant vice-chairmanship. And, BUSINESS WEEK has learned, Berkeley labor economist Janet L. Yellen, another pro-growth voice, is in line to be nominated as a governor.

BOOM SIGNS. At its heart, the Fed's thinking is simple: Move now or risk an acceleration of inflation next year. Fed officials first became seriously concerned last December, when the economy showed unmistakable signs of a boom as the expansion neared the end of its second year. They also agreed that the 3% federal funds rate--the charge on overnight interbank loans--was too low. But officials didn't act immediately.

When the Federal Open Market Committee met on Feb. 3-4, there was quick agreement on the need to raise rates. Insiders say the only debate centered on how high to go and how quickly to proceed. Greenspan refuses to say what target he has in mind, but other Fed officials have hinted it could be in the range of 4% to 41/2%. The idea is to hold short rates at 75 to 150 basis points above the current inflation rate. "We have a range," says one Fed official. "If we didn't, we'd be flying blind. But we're not."

At the February meeting, some Fed officials, including Governor Lawrence B. Lindsey, argued for moving to the target range in one jump. But Greenspan, ever the gradualist, argued that after five years without a rate increase, such a drastic step would be too much for the markets. Ultimately, the FOMC agreed on a strategy to raise rates in quarter-point steps: on Feb. 4, at the next FOMC meeting Mar. 22, and again halfway toward the next meeting scheduled for May 17. Fed officials hint that another hike is coming in May, taking federal funds up to 4%.

The approach isn't selling well on Main Street. Even before the latest Fed action, Goodyear Tire & Rubber Co. Chairman Stanley C. Gault cautioned: "We've got be to be very careful we don't spook the birds off the roof." Now, he adds, "the three increases in rates have been premature." Indeed, economic growth already has slowed from 7% in last year's fourth quarter to an estimated 3% or 4% in the first quarter of 1994. And the interest rate hikes since Feb. 4 are certain to slow such interest-sensitive sectors as autos and housing later this year. Indeed, the Clinton Administration won't suffer in silence through more than another quarter point or two. "The President's not thrilled," says a senior Clinton economic adviser. "But he understands that this may be necessary for the long-term good of the economy."

Meanwhile, Greenspan has left a trail of confusion with his quick public embrace, and equally swift abandonment, of a series of monetary guideposts. For the past year, the Fed has looked at everything from gold and other commodity prices to inflationary expectations to the level of financial speculation as guides to preemptive action.

Ironically, the Fed could be adding to the confusion with a new effort to make its proceedings more public. In response to demands from congressional Democrats, the FOMC took the unprecedented step of announcing its February rate increase immediately. This ended a long tradition of delaying disclosure for six weeks and letting the markets guess what had been done. The markets responded with a massive sell-off; the Dow dropped 96 points in one day.

The Fed also set a trap for itself by announcing that the February vote was unanimous. When it refused to disclose the vote at the March meeting, it immediately set off speculation that there had been dissents from the decision. The Fed still hasn't decided what to do if the FOMC decides to take no action at a meeting. And it's still unsure whether to speed release of FOMC minutes and expand summaries that gloss over sharp divisions within the panel.

While Fed governors argue about how much sunshine to let into their deliberations, they remain united behind the correctness of their early-strike strategy. "Inflation comes from an overheated economy," says Governor Edward W. Kelley Jr. "The economy is growing at a rate that's fot sustainable over the long term. Monetary policy works with time lags. You can't wait until you see evidence of inflation. By then it's embedded in the economy and becomes much harder to wring out."

Though many outside economists support this view, some think the Fed is too quick on the trigger. They concede that the economy is at a stage of expansion where, historically, inflation has begun to be a problem. But for now, global competition and rapid productivity growth in the U.S. have depressed price hikes. Tighter labor markets and supply bottlenecks in the U.S. may no longer be harbingers of inflation when there's so much slack worldwide. "There's no reason to believe you're running into capacity constraints or inflation problems," says University of Texas economist James K. Galbraith. "The Fed is creating a demon that doesn't exist."

The Fed's moves, though, aren't causing immediate alarm in executive suites. Many companies have made themselves less vulnerable to rate increases by reducing indebtedness and refinancing long-term borrowings at low rates. Case in point: Union Carbide Corp. reduced the rates on 90% of its debt from 9% to 7% through refinancing.

Other corporations reacted to recent rate hikes by improving their balance sheets. Many followed the approach of Specialty Foods Corp., a $2.2 billion maker of dairy and bakery products in Deerfield, Ill. In April, Chief Financial Officer Paul J. Liska rushed to convert part of the company's $400 million in variable-rate debt to a fixed-rate. "I went as long as I could on everything I had," he says. "I'm looking like a genius today."

A few more rate hikes, though, and prospects could change. C.J. Vitner & Co.--whose potato chips are a staple in Chicago bowling alleys and taverns--pushed its distribution network to the limit after landing a contract to sell its chips in Jewel Food's 175 stores. But President William A. Vitner says the threat of further hikes could prevent the chipmaker from going ahead with a $5 million to $6 million warehouse expansion. "We would shelve that for the moment," he says. "We're tied to the prime rate, so every move means we're paying more." Indeed, major banks, which trimmed the prime very slowly while the Fed was cutting rates in 1990-92, have been quick to raise it from 6% to 63/4%.

Overseas, meanwhile, higher rates have dealt a rude surprise to many economies counting on cheap money to fuel badly needed recoveries. From Asia to Latin America, a flood of corporate financings has slowed to a trickle as stock and bond markets have dried up. In Japan, long-term interest rates have climbed more than a half-point, to 4%. That may help stall a meager recovery that some economists think will bring no better than 1% GDP growth in 1994. And yields on 10-year German government bonds have shot up nearly three-quarters of a percentage point, to 6.5%, even though the country is struggling to emerge from its worst recession in decades.

Back at the Fed's marble headquarters, the complaints of Main Street aren't going unheard. But the central bank believes that a slight slowdown in growth is a small price to pay for a sustained noninflationary expansion. The Fed's goal is to keep the economy growing at 2.5% to 3%, while keeping inflation below 3%.

Historically, the Fed's attempts to make such fine calibrations in the economy have been a painful failure. So no matter how measured it appears in its execution, Greenspan's gradualism carries a large risk for the U.S. economy. Head off inflation, or choke growth: Which will it be?

In the atrium of the Fed headquarters hang two chandeliers decorated with the 12 signs of the zodiac. Fitting symbolism, veteran Fed watchers would say. Once you go behind the technical explanations for what the Fed is doing, what it ultimately comes down to is fate. With Fed policy at a turning point, Alan Greenspan's best hope, along with good gut instinct, may be that success is written in the stars.

WHY GREENSPAN DOESN'T SMILE MUCH

Here's why it's so tough for the Fed to create monetary policy today:

PHANTOM MONEY

Anticipating inflation has become trickier. Because of the investor shift from savings instruments to mutual funds, traditional measures of money are no longer as accurate. As a result, the Fed has variously said it tracks "inflationary expectations," commodity and gold prices, and the "neutrality" of interest rates.

BAD INDICATORS

The globalization of the economy has made some indicators less meaningful. The shift to overseas manufacturing has distorted capacity utilization measures, and productivity gains have challenged theorems about the trade-off be-tween unemployment and inflation.

GLOBAL MARKET MANIA

The growth of foreign-exchange markets and speculative instruments has led to a global web that can suddenly unravel. The sharp bond market reaction to the Mar. 22 tightening surprised Fed officials, who hadn't realized how vulnerable highly leveraged global credit markets had become.

POLITICAL PRESSURE

Restive Democratic lawmakers are forcing the traditionally secretive Fed to operate more openly. But the Fed's tentative efforts to disclose decisions have backfired by roiling the stock and bond markets.

FORGING MONETARY POLICY:

ANATOMY OF ATIGHTENING

OCT. 21, 1993

Skittish bond markets roiled by an upbeat Philadelphia Fed analysis of regional economies.

NOV. 17

In a victory for the Administration, Congress approves North American Free Trade Agreement.

NOV. 30

Oil prices plummet by $1 a barrel on OPEC's decision not to lower production;

consumer confidence up sharply in November.

JAN. 12, 1994

Clinton seeks a special prosecutor to investigate his investment in the Whitewater development.

FEB. 4

Fed announces quarter-point hike in its short-term rate, to 3.25%; stocks fall 96 points.

FEB. 9

U.S. suspends trade talks with Japan on the eve of Clinton's summit with Hosokawa.

MAR. 1

Fourth-quarter GDP growth revised to 7.5% from earlier 5.9% estimate, atop strong corporate profits; long-bond yield climbs to 6.77%.

MAR. 22

Fed votes to raise short-term rates again; bond yields soar in the days following.

MAR. 23

Mexican presidential candidate Luis Donaldo Colosio assassinated as preelection tension spills over.

APR. 18

Greenspan announces another quarter-point increase in the Fed funds rate. Stocks take another hit.

FEB. 1

Bush appointee David Mullins resigns as Fed vice-chairman; bonds fall on the news.

JAN. 31

Greenspan warns Congress that he'll raise rates "at some point." Dow Jones industrial average hits high of 3978.Owen Ullmann and Dean Foust in Washington, with Greg Burns and Susan Chandler in Chicago and bureau reports


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