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The Federal Reserve and the Economy
With Post reporter John M. Berry

Monday, March 20, 2000 at 1 p.m. EST

Are you interested in the inner workings of the Federal Reserve and whether the group is likely to announce an interest rate increase on Tuesday?

John M. Berry has covered the economy and the Federal Reserve for 30 years, the last 21 with The Post. His work is closely followed on Wall Street for insights into the thinking of Fed officials, many of whom he interviews on a regular basis.

Berry will take your questions and comments at 1 p.m. Monday.

Continue this discussion on our message board

washingtonpost.com: Welcome to washingtonpost.com's Live Online with Post reporter John M. Berry. We'll start off with the million dollar question - Will the Fed raise rates tomorrow and if so by how much?

John M. Berry: Well, everybody is taking Fed Chairman Alan Greenspan at his word, which is that spending by businesses and consumers is increasing faster than the U.S. economy's ability to produce the goods and services everyone is demanding. Even though inflation is not currently a problem--obviously not counting what is happening to oil and gasoline prices--Fed officials fear that if economic growth doesn't slow, sooner or later inflation will begin to rise. To make growth slow, they have already raised rates a full percentage point since last June and will undoubtedly add another quarter-percentage point tomorrow. What happens after that will depend on economic developments, but again, just about everyone expects at least one more increase and possibly several more if growth doesn't slow.

Chicago, Illinois: Please share your opinion on the best investment routes, T-Bills, stock market, or other conservative investment vehicles >in the next 5 years, in light of the Federal Reserve's expected future rate hikes. I am hoping to smartly invest 100K for retirement in 10 years.

Arthur J. Reliford

John M. Berry: I am not really in the business of giving investment advice, but I will share just a couple of thoughts. Stocks have been a great way to go in recent years and many investment professionals still say that the best long term bet is stocks. But they are say no one should be buying stocks expecting that the huge gains of recent years will continue. Some mix of stocks and fixed-income securities is a typical suggestion, with a larger share in stocks than otherwise.

Vienna: In the past 8 months, the Fed has raised the interest rates by one percentage point and manufacturers have announced over 100,000 job reductions. Is there any connection here? "There's a threat of inflation?" Where? When? How? With the Internet booming with mds. at bargin prices and with the big discount stores in heavy competition, I can only see prices on consumer goods falling. One sector is experiencing an up-tick and that is energy, if we don't count the increase in interest rates -home mortages have already zoomed upwards, therefore we cannot ignore]. Energy prices are not the villian here. It is interest, which causes everything to cost more. Even so, competition is still alive and well. All reports provide evidence of very stable market conditions. More people are working, though at modest wages, than ever before. Companies will not expand under the threat of higher interest rates. They will not expand in a shrinking economy, either. This false sense that the present positive economy must be stopped is totally out of touch with reality. We must protest.

John M. Berry: I won't try to address all the points you raise, but I will say that the most significant reason that manufacturing employment has not zoomed is not higher interest rates but the incredible increases in labor productivity in that part of the economy. In the fourth quarter of last year, factory productivity rose at more than a 10 percent annual rate. While demand for goods has been increasing rapidly as well, it hasn't been going up as fast as productivity--so firms are producing far more goods with about the same number of workers.

Downtown DC: have to say, in the beginning, Greenspan made some good choices that helped stabilize our economy. The problem is, as he himself has said, he doesn't know what the economy is going to do next. In a economic crisis, he was just the guy for the job. Right now, however, he's overreacting immensely. What is this guy's motivation.

John M. Berry: Greenspan's concern is that, in his opinion, the economy cannot continue to grow as fast as it has been without sooner or later causing more inflation. And a rise in inflation would eventually bring the long expansion to an end, in large part because the Fed would have to raise interest rates enough to halt that increase in inflation. You are right to note that neither Greenspan nor anyone else has a really good understanding of what is going on in the economy right now. But he is looking at two indicators that the current growth rates are too high. The first is that the nation's pool of people who say they want a job but don't have one has been steadily shrinking. The second is that the U.S. trade deficit is deepening rapidly, an indication that the country is consuming or investing more than it is producing. The problem is that to keep the books balanced, an ever greater inflow of foreign capital is needed to finance that deficit. Attracting that capital could be a problem is the deficit keeps getting bigger and bigger. Of course, not everyone agrees with his interpretation, as you suggest.

Rosslyn, VA: A couple of months ago it seemd the fed had good cause to want to keep raising rates. But the markets appear to be correcting themselves. Inflation is far from being out of control and unemployment is still low. What possibly could Greenspan be worried about.

John M. Berry: My previous answer covers a lot of what he is worried about. Certainly he and his colleagues don't want to choke off growth and they do not see inflation as a current problem at all--again except for oil which has very little to do with the level of interest rates. But they also know that every recession in the past 50 years was preceeded by an acceleration of inflation and they want to slow growth enough to keep that acceleration from occuring.

Washington DC: With rates rising and the Treasury buying back debt are there any real advantages for the bond market in all of this.

John M. Berry: I guess you could say there is an advantage for bonds if the Fed is successful in keeping inflation under control since long-term rates are highly sensitive to actual and expected inflation. Of course, folks who held Treasury bonds at the beginning of the year have made money as it has sunk in that the supply of Treasury bonds is shrinking and is likely to do so indefinitely.

fairfax: C'mon, this is a democracy? The Fed is the unofficial -and most powerful- fourth branch of our government! I'm certainly no fan of the Fed. They ran me out of business in the past, by suddenly raising interest rates. I was happily building homes, as a building contractor, back in 1979, when Paul Volcker, the then-chairman of the Fed suddenly decided to raise interest rates. With mortgage rates skyrocketing from 8% to 14%, nobody was buying homes, and I was left holding the bag. In the process, I lost all my operating capital, and had to turn my back on work I loved to do. I say: Get rid of the Fed! It is much too powerful for the good of this country.

John M. Berry: Yes, the Fed certainly is powerful in terms of the economy. However, it was created in 1914 because of the recurring financial "panics" that regularly paralyzed the economy during the 19th century and the begining of the 20th. In those cases, there was a literal shortage of money that no one could do anything about. Even with the Fed, the Great Depression occurred because central bank officials did not understand what was happening and followed truly bad policies. At the end of the 1970s, the problem--not from your point of view but from that of the policymakers--was that inflation had been allowed to get totally out of hand. Yes, it was extremely painful for many individuals and companies when rates rose so high, but what would have happened if the Fed had not tried to bring inflation under control again? Since they did so, the United States has had nearly two decades of economic growth with generally low inflation, interrupted by a mild recession in 1990-91. The pain was awful for many people, but from the Fed's point of view it was unfortunately unavoidable.

Rosslyn, Va: How do you address the notion that the valuation models for markets and measures of econmic health traidtionally used by the economists are outdated? Many say the explosion of the Internet and productivity as well as a new consumer and investor psychology turns a lot of the tools the fed and other economists use on its head.

John M. Berry: Everybody I know agrees that many of the old models don't explain today's economy or markets very well. But there is no reason to think that the Fed tools, for instance, can't still slow economic growth. Higher interest rates really do matter, especially for households and smaller, traditional firms who can't sell tech stock to the public.

Herndon: My company's No. 1 concern -like most firms-is the tight job market. It's having an impact on our bottom line and we're having to pay higher salaries and benefits to hire and retain workers. We're definitely seeing wage pressure, at least in this area. Doesn't that have to show up soon in a BIG way in the inflation numbers?

John M. Berry: The question is, what else is your firm doing? The Fed's periodic surveys of nationwide economic conditions find exactly the conditions you mention but also that firms are finding ways to offset the higher labor costs, such as boosting productivity or reducing non-labor costs. The key is that in most instances firms are convinced they cannot simply raise their selling prices or else they will lose customers. Since profit margins are, in general, still very solid, that approach seems to be working, though obviously not for every firm.

Waldorf, MD: What about our trade deficit. This was a hot topic last year. Does anyone care that it is still through the roof? Will foreign consumer eventually balance the load or is the U.S. going to continue to allow this frenzy of imports to bury us?

John M. Berry: Yes, as I mentioned in an earlier answer, there are some people concerned about the trade deficit, among them Alan Greenspan. One reason the deficit is so large is that most foreign economies have been going through periods of modest or very weak growth compared to the United States. That has meant that our demand for imports has gone up much faster than demand for U.S. exports abroad. The relatively high value of the U.S. dollar, which makes our exports more costly, has also been a factor. However, if the Fed succeeds in slowing growth here and growth abroad picks up, which seems to be happening in Asia except for Japan and in Europe, the deficit should at least stop getting bigger and more likely begin to shrink.

College Park: What do you expect will happen to the declining personal savings rate?

John M. Berry: Well, at some point it will have to stop declining. As the late Herb Stein once wrote, if something can't go on forever, it will stop. Remember that personal saving is measured as a share of disposable personal income, that is, income for current production. For most of us, that's basically our take home pay. And it is also a residual. That means that the Commerce Department estimates total disposable income and total consumption spending, subtracts the spending from the income and reports whatever is left. But if you own stocks or a home whose value has gone up, those capital gains, whether you sell the assets and realize the gains or just leave them in paper form, are not included as savings. The gains are not counted as part of income from current production. But the owner of the assets certainly feels richer and may thus be willing to spend more out of current income because he still has a big and probably growing nest egg.

Arlington, VA: Do you think that any increase the Fed may recommend will immediately translate into consumer -read, mortgage- rate increases? It seems that the mortgage market seems to be an almost stabilizing influence.

John M. Berry: Back in 1993 U.S. banks began to keep their prime lending rates locked at 3 percentage points above the Fed's target for the overnight federal funds rate, which currently is 5.75 percent. Assuming the Fed raises that target tomorrow to 6 percent, then the prime will go up by the same amount. Since rates on many home equity loans, unpaid credit card balances and loans to many smaller businesses are directly tied to the prime, those rates would rather automatically increase. Mortgage rates on the other hand tend to follow, more or less, changes in yields on 10-year Treasury notes because most housing finance comes from the same pool of capital funding those Treasury notes. How a higher target for overnight rates will affect yields on the notes is hard to predict, but since the likely Fed action is so widely expected, tomorrow's increase is probably fully built into current note yields.

Arlington, VA: It seems the biggest inflation threat is in the energy sector. According to last week's CPI numbers everything else such as food and computers is being kept in check. What impact can higher oil prices really have of the rest of the economy and do you think greenspan can justify a hike based on energy prices alone?

John M. Berry: Greenspan in congressional testimony last month made it clear that the Fed does not intend to use the big rise in oil prices as an excuse for raising rates. World oil inventories are very low and that has driven up prices, he told members of Congress, and there is nothing the Fed can or should do about that.

Dupont Circle: Just curious. What is your opinion on Greenspan's performance overall? Specifically over the past 6 to 8 years. A lot of people give him credit for our economy's smooth sailing. Does he deserve the credit?

John M. Berry: I'm afraid this has to be my last answer.

Greenspan certainly deserves a great deal of credit, though he would be the first to say that he is not a one-man band at the Fed and that the Fed isn't the only player either. For instance, when President Clinton announced he was appointing him to a fourth four-year term as chairman, Greenspan thanked Clinton for all the nice things he had said about him and for the fiscal discipline his administration had followed. Greenspan has said that the government's moving its budget position from one of large persistent deficits to large and growing surpluses has been a major help in stabilizing the economy. Of course, Congress has played an important role in making that happen along with Clinton. More broadly, credit can reasonably go to plenty of others as well. Deregulation that began in the middle 1970s has freed up the economy and allowed it to be more responsive to market forces. The end of the Cold War has been important, especially in terms of government spending. Lower taxes have helped too. So there's lot of credit due to lots of people.

washingtonpost.com: That's all the time we have today. Thanks to John for sharing his insight and expertise. You can continue this discussion on our message board

© Copyright 2000 The Washington Post Company

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