Greenspan's Preoccupation with Profits


By Rich Miller For the past five years, Federal Reserve officials have been regularly contacting Thomson Financial equity strategist Joseph S. Kalinowski for consensus earning forecasts by Wall Street analysts. But the contacts have become much more frequent of late. With earnings, and earnings expectations, plunging, they're checking with him at least once a week to get the latest news on the profits front. Of particular concern to the Fed officials, according to Kalinowski: the steep drop in high-tech companies' profits. "They, like everyone else, have been amazed at how far those earnings have come down," the strategist says.

It's no mystery why Greenspan & Co. is so worried: Pinched profit margins are a threat to the economy as far as the eye can see. In the near term, the Fed is concerned that the profit squeeze will prompt companies to cut investment and pare payrolls even further, tipping an already weak economy into recession.

PERILS AND PITFALLS. The Fed is also worried that the earnings slump will sock the stock market and sap consumer spending via the so-called wealth effect. In the longer run, the Fed frets that reduced business investment in computers and other efficiency-enhancing equipment will undermine the strong productivity growth that has been the hallmark of the New Economy. In the latest bit of bad news on the investment front, the Commerce Dept. said on Apr. 25 that core capital-goods orders fell in March, the fifth time in six months.

But the Fed's focus on plumping up profits carries some risks. If companies try to rebuild earnings by raising prices, the Fed won't only have an economic slowdown to worry about -- it will be faced with an inflation problem as well. "It's not hard to construct stagflation scenarios in which price pressures continue to rise in the face of weak business conditions," says Louis Crandall, chief economist at consultants R.H. Wrightson & Associates.

By aggressively cutting rates, Greenspan is betting that the New Economy is alive and kicking and can insulate the U.S. against any inflation outbreak. As far as the Fed chief is concerned, Corporate America hasn't even begun to exhaust the many productivity-enhancing and profit-making opportunities the New Economy affords.

LONG ON OPTIMISM. Take corporate purchasing managers at the nation's manufacturing companies: A December survey by the National Association of Purchasing Management found that 95% of the managers contacted felt they could reap further big gains in efficiency from the application of technology. As long as companies don't overreact to the current earnings squeeze and indiscriminately slash investment, Greenspan believes the long-term outlook for the growth of productivity and profits is bright.

Stock market analysts seem to agree. Yes, they've drastically cut their short-term earnings forecasts as the economy has slowed sharply. But they remain surprisingly sanguine about the longer-term outlook. According to Kalinowski, Wall Street analysts expect operating profits of companies in the Standard & Poor's 500 to rise on average by about 16% per year over the next three to five years. That's down only slightly from a high forecast of 18.7% growth in August of 2000 and compares favorably with this year's expected 2.3% drop.

Foreign investors appear to be on board as well. The continued strength of the dollar -- despite the economic slowdown, it's trading near a 15-year high against other major currencies -- is a vote of confidence by foreigners in America's long-run economic potential.

But one group is feeling twitchy: Domestic bond investors, who have been dumping Treasuries. The investors are worried the Fed has become so obsessed with boosting corporate profits that it's ignoring a host of inflation warning signs, from sagging productivity growth to a renewed rise in gasoline prices. Greenspan is scheduled to speak to the Bond Market Assn.'s annual meeting on Apr. 27 and could use that opportunity to try to allay investor concerns.

ACCEPTABLE RISK. One of Greenspan's colleagues, Dallas Fed President Robert McTeer, has all but admitted that bond investors are right to feel a bit slighted. In a speech on Apr. 20, McTeer acknowledged that inflation could end up being a problem for the central bank, but he argued that, for now, it has to take a rear seat in the drive to get the economy moving again. "Under the current circumstances, I personally think we need to put concerns about inflation on the back burner for awhile and save the economy from the 'R' word," he said.

With the U.S. poised on the treacherous ground between recession and recovery, that's undoubtedly the right position for the Fed to take. But once the economy starts firing on all cylinders again, the central bank will quickly need to turn its attention back to its main mission of fighting inflation. Not to do so would risk a replay of the boom/bust cycle that it's now struggling so hard to avoid. Miller covers the Fed for BusinessWeek from Washington


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