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Dollar Doldrums Alone Won't Force Rates Up


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DOLLAR DOLDRUMS ALONE WON'T FORCE RATES UP

There's an old rule in currency intervention: Don't try to row upstream. On June 24, the Federal Reserve and 16 other central banks spent more than $3 billion trying to prop up the U.S. dollar against market forces determined to send it the other way. As usual, the market won.

Coming off this failed effort amid stubborn dollar weakness and its depressing influence on U.S. bond and stock markets, the Fed's policy committee will sit down July 5-6 to plot strategy. The popular question: Will the Fed have to raise interest rates to shore up both the greenback and sagging investor confidence in U.S. securities?

If the trends in the data are any indication, such a move seems unlikely--if not foolhardy. The numbers continue to show that economic growth is already slowing, a point that was clear in the Fed's own regional survey prepared for its upcoming meeting. In addition, inflation prospects remain reassuring, as Fed Chairman Alan Greenspan himself noted in testimony on June 22.

The latest evidence of these trends: Sales of existing homes dipped in May, and while purchases of new homes rose in the month, sales appear to have peaked. Consumers remain confident (chart), but rising rates and low savings will temper the boom in durable goods. Indeed, factory orders for them posted a tepid gain in May, leaving bookings no higher than they were in January.

At the same time, inflation news has improved. Oil prices are down about $1 per barrel since mid-June, and commodity prices have retreated from their recent highs, despite surging coffee prices caused by frost in Brazil.

Besides, where interest-rate policy is concerned, the Fed just doesn't place much importance on the dollar. It never has. The central bank has always given top priority to domestic issues such as growth and inflation. If the Fed judges that inflation control doesn't require higher rates, then it will not act solely to bolster the U.S. currency.

Such a bold cure could even cause more harm than good by admitting that a disease exists. Economic fundamentals in the U.S. should be more supportive of the greenback. In fact, the dollar's weakness has been narrow, focused mainly against the Japanese yen and the German mark. And even there, the decline has been orderly.

Moreover, the dollar-yen relationship looks increasingly more like a problem for Japan than for the U.S. The strong yen presents tough problems for Japanese exporters, and on June 29, the yen hit a new high after the selection of a Socialist Prime Minister, Tomiichi Murayama. The vote lowers the chance for deregulation and economic stimulus needed to cut Japan's huge trade surplus, the major reason for the yen's strength.

Against this backdrop, the Fed seems most likely to put off any rate hike until its August meeting, if then. The policymakers are still monitoring the impact of the large half-point hike on May 22, along with that of previous increases. Another hike in the face of moderating growth and tame inflation would risk looking like overkill, only feeding tensions between the Fed and the White House.

Although the effect of past Fed tightening is just now beginning to show up in the economy, the impact is clear enough from the monetary data. In particular, bank reserves--the basis for money creation--have fallen at an annual rate of 7.2% since early March. The weaker money numbers strongly suggest that Fed tightening has already set up monetary conditions that often foreshadow slower economic growth.

The No.1 casualty of the Fed's tightening is housing. Clearly, home buying and building are in no danger of a slump, but housing's biggest contributions to this expansion are history (chart). Sales of new single-family homes rose 4.2% in May to an annual rate of 738,000, but the second-quarter tally is well below the pace in 1994's fourth quarter. The same is true for sales of existing homes, which fell 0.7% in May to a 4.09-million annual rate.

That fourth-quarter peak is unlikely to be regained now that 30-year fixed mortgage rates are averaging 8.65% for the week ending June 24. The Mortgage Bankers Assn.'s tally of home-purchase mortgage applications is down sharply, and in mid-June it fell to a 11/2-year low.

Still, housing has its supports. The Fed's rate hikes since February appear to have had no appreciable impact on consumers' spirits, which have been buoyed by stronger job growth. The Conference Board's index of consumer confidence rose to 92 in June, up from 88.9 in May. For the second quarter, confidence was the highest in almost four years.

Better feelings about jobs and incomes are offsetting some of the impact of higher rates by giving consumers more confidence to take on debt. At the same time, the cost of carrying that debt has fallen to the lowest percentage of aftertax income in a decade, and problem loans are down (chart).

But despite the better finances of consumers, higher rates will take a toll on consumers and manufacturers. That's because their biggest impact will be on the demand for rate-sensitive durable goods, such as cars and home-related goods, especially since those items were the main beneficiary of last year's refinancing windfall.

Now, however, the Mortgage Bankers Assn. also says that refinancing activity has all but dried up. Its index of mortgage applications for refinancing has plummeted 91% since last October, when rates hit their low point.

Buying plans for rate-sensitive items are indeed down, says the Conference Board in its June survey. And that falloff is showing up in manufacturers' order books. Orders for durable goods rose 0.9% in May, after a slim 0.1% gain in April. Excluding commercial aircraft and defense, two small and volatile sectors, bookings barely rose in May, and they are well below their March level (chart).

With signs of slower growth increasingly evident and with any obvious inflation pressures still absent, the Fed will be hard-pressed to rationalize another rate hike at its July meeting, especially so soon after a half-point hike in both the discount rate and the more important federal funds rate.

As for the dollar, a small boost in rates now would do little to alter the underlying reasons for the dollar's weakness. A hike will not reduce Japan's trade surplus, it will not shrink America's current account deficit, and it will not restore lost international confidence in the Clinton Administration.

Rather than lift rates, the Fed is most likely to continue its intervention efforts when it deems such action necessary as an international show of support for the U.S. currency--even though the attempt is often little more than a crapshoot.JAMES C. COOPER AND KATHLEEN MADIGAN


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