Federal Reserve's Big Balancing Act


FOLD or go down?

That's what economists and millions of homeowners are wondering about interest rates as Federal Reserve policymakers meet for two days in Washington beginning July 5.

Watching, too, will be President Clinton, whose fortunes in next year's presidential election will pivot in part on the state of the nation's economy.

It won't be an easy decision for Fed Chairman Alan Greenspan and his colleagues on the Federal Open Market Committee (FOMC). If they sit on interest rates, the risk of recession could rise. But lowering them could spur inflation.

The task is complicated by conflicting economic signals now emerging. After seven interest-rate increases in one year designed to cool the economy and keep inflation in check, the nation's gross domestic product (GDP), its output of goods and services, is sputtering. If the Fed actions have a delayed impact, growth could be even slower later in the year.

While employment appears weak and retail sales are trailing off, the good news is a boost in orders for industrial machinery, electronic components, and other supplies that make factories hum. Business borrowing and new-home sales are strong.

But there is the nagging problem of inventory buildup - what economists call a harbinger of recession. Factories have had trouble emptying shelves of enough stock to justify more production. Automakers account for much of the slack.

Fed watchers worry that a prolonged inventory adjustment will mean lower wages - even job losses - and result in a downward spiral of more unwanted inventories and production cuts.

But some analysts insist that if the Fed eased the money supply by lowering rates, borrowing costs would nudge reluctant buyers - including car shoppers - to make big-ticket purchases.

Consumer discomfort

Consumers have already registered their discomfort with the economy's prospects. According to the New York-based Conference Board's most recent monthly reading, consumer confidence in June plunged to its lowest level in three years.

Some economists attribute the drop to concern about recession and worry over possible layoffs. And while many take that as a clear sign of trouble, given that consumer spending makes up two-thirds of the economy, Fabian Linden, head of the Conference Board's Consumer Research Center, does not. The current confidence level, he says, is still at a level associated with a strong economy.

Sung Won Sohn, chief economist of the Minneapolis-based Norwest Corporation, is not among those economists who are forecasting recession in the coming months, "unless, of course, the Federal Reserve fails to lower rates."

The fact that Mr. Greenspan is talking about recession leads Mr. Sohn to believe that the Fed will move to stave it off. "No sitting chairman of the Federal Reserve Board has ever openly discussed the risks of a recession as Greenspan did" in his speech to the New York Economic Club two weeks ago.

Much of Wall Street has already taken a cue from the speech, with many investors seeking potentially higher returns from stocks and bonds. Some money managers warn that the market will tumble if there is no rate cut.

Sohn ventures that Greenspan will cut rates by a half a point, if not this week then by August for sure. "He sees risk, and he'll take out an insurance policy," he says.

Greenspan not only is trying to avert an economic slide, he's anxious to please President Clinton, who will decide on the chairman's reappointment in March 1996, Sohn says. The White House is interested in lowering rates to avoid a possible voter backlash at the polls next year.

Sohn, who spent last week in Washington talking to government policymakers about overall prospects for US economic growth and stability, reports that "no one in Washington seriously thinks that inflation is a problem right now."

Even Greenspan, a long-time warrior against spiraling prices, has practically "declared a victory over inflation," Sohn says.

To Robert Brusca, chief economist of Nikko Securities Co. International Inc., the talk of Greenspan's attention to recession is overplayed. Inflation remains the Fed's focus, he says, invoking a quote from Greenspan's speech: "It is important that progress [toward lower inflation] continue .... I am also confident that ... will be in the context of our longer-term goal of price stability. A consistently disciplined monetary policy is what our global financial system increasingly requires and rewards." Brusca offers his translation: "What this means in layman's terms is: With inflation still rising like this will the Fed ease? Not without a very clear reason."

Intent on slowdown

Though they express it in cryptic central-bank language, the newest members of the Fed may see a reason to raise rates. They sound like they are intent on fighting a slowdown with lower rates. "I would not want to ignore or even minimize the [economy's] downside risk," Federal Reserve Board Vice Chairman Alan Blinder said in June.

Shortly thereafter, Janet Yellen, the board's most recently appointed governor, told the Bureau of National Affairs: "I certainly don't mean to be screaming fire in a movie theater ... but the more you see [the negative data from unemployment to inventory accumulation], the more difficult the transition is [to a slower-growth economy for an extended period]."

The FOMC meets today and tomorrow.

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