Monetary policy in the United States has become hostage as never before to international economic developments.
The Federal Reserve's focus remains on the domestic U.S. economy, but the nation's immense trade deficit and the response to it in American financial markets has severely limited the central bank's policymaking freedom.
Just before Labor Day, with virtually no evidence of any acceleration in the nation's underlying rate of inflation, the Federal Reserve Board tightened monetary policy by raising its discount rate for the first time in more than two years. The increase raised the rate -- which is what the Fed charges when it loans money to financial institutions -- from 5.5 percent to 6 percent.
It was understood by Fed officials that a number of other key short-term interest rates also would rise in response to the action, and they have.
While the U.S. economy is growing at a healthy rate, according to a wide range of economists, including those at the Fed, it is not expanding so rapidly that under normal conditions the central bank would have been boosting interest rates to cool it off. Rather, the move in early September was in response to a sharp rise in market-determined long-term interest rates that in turn had been set off by a drop in the value of the dollar on foreign exchange markets, worries about the trade deficit and fears of a surge in inflation.
The principal hope behind the discount rate increase was that a strong signal from the Fed that it intended to resist any acceleration of inflation would calm the roiling financial markets and perhaps bring long-term rates back down a bit. So far those hopes have not been realized. At the end of last week, yields on long-term federal government bonds were still around 9.7 percent and fixed-rate home mortgage rates were close to 11 percent.
The four members of the Fed board who voted for the discount rate increase -- two were out of town and one seat is vacant -- also felt that the economy is strong enough that a half-point rise in short-term rates would do little if any damage. Moreover, while there was little evidence that inflation had increased or was about to do so, it would not be impossible for rising inflationary expectations to generate higher inflation -- a sort of psychological self-fulfilling prophecy -- if those expectations were ignored, the members felt.
The fear of inflation has been fed, in part, by an almost constant downward pressure on the value of the dollar. The Reagan administration has promised other industrial nations it will try to keep within a fairly narrow range compared to their currencies, but most analysts expect it to keep falling until the United States begins to make significant progress on its large and still growing deficit in transactions with the rest of the world. Prior to his appointment as Fed chairman in June, Alan Greenspan's own forecast was that the longer-term course of the dollar would be downward, even if it rallied in the short run.
Part of the dollar's problem, which Fed officials fully recognize, it that the appetite of private foreign investors for putting money in the United States has not kept up with the need to finance a U.S. current account deficit that could easily hit $160 billion this year. The Commerce Department reported last week that the deficit on current account -- a broad measure of international transactions covering trade in goods and services, earnings on foreign investments, tourism, public and private pension payments and remittances and some military transfers -- reached $78 billion in the first six months of 1987.
For international financial purposes, it is the current account deficit that is important, and it is by its very nature a nominal amount. If the terms of trade shift against the United States -- that is, the value of the dollar goes down -- the initial impact will usually be to widen the trade deficit in nominal terms well before the exchange rate changes affect the volume of trade. Eventually, the lower value of the dollar should lead to reduction in the trade deficit in both volume and nominal terms.
The United States is in the middle of that process now. The trade deficit is improving in real terms but not in nominal terms. For instance, in the second quarter, exports of goods and services rose at a 17.9 percent annual rate after adjustment for inflation. Imports, after falling in the fourth quarter of 1986 and the first quarter of this year, rose at an 11.1 percent annual rate.
Thus, the second quarter was the third three-month period in a row in which trade volumes shifted in favor of the United States. However, import prices have been going up enough faster than export prices that the deficit has continued to get bigger in nominal terms.
Each month's worth of additional bad news on the trade front makes financial market participants more leery about the future of the dollar and of inflation. This evidently was what was behind the sudden spurt in long-term interest rates last month.
Against this background, there is another reason the Fed finds itself in a box these days. It is well known that faster economic growth tends to make a nation's trade deficit worse, not better. At the margin, a larger share of the added demand for goods and services usually is satisfied by imports. Therefore, the stronger the economy turns out to be this fall, the sharper will be the Fed's dilemma.
It is quite possible that the central bank could find itself in the uncomfortable position of seeking to limit economic growth in order to reduce the trade deficit by holding down demand for imports.
Again, the issue is not just economic growth in the United States, but growth here relative to that in Japan, West Germany and other industrial nations buying U.S. exports. The Japanese reported last week that their economy was flat in the second quarter, but domestic demand grew at more than a 5 percent pace. There is a general concern among Reagan administration and Fed officials that domestic demand growth in Germany is faltering.
Many analysts believe that these international economic forces, and the response in U.S. financial markets, will force the Fed to continue to raise interest rates in coming months. Some of the analysts now expect a recession will be the result, probably hitting late next year or early in 1989.
Certainly Federal Reserve officials would like to avoid a recession. Aside from what it would mean in terms of lost jobs and output, a slump could bring down some shaky financial institutions. With the generally high level of debt throughout the economy, high interest rates and a recession could drag some highly leveraged companies under, too.
Yet Greenspan, before taking his new office, often argued that letting inflation get out of hand again would be far more costly to the nation in the long run than taking steps to damp it down in the beginning.
There is no reason to think he has changed his mind, and the increase in the Fed's discount rate suggests he has not. Had the economy been weaker, chances are the increase would not have occurred. On the other hand, if the economy had been weaker, inflationary expectations might have been lower, too.
The principal goal at the Fed under Greenspan -- as it was under his predecessor, Paul A. Volcker -- is to contain inflation. If it gets out of hand, monetary policy sooner or later would have to be tightened to the point that a recession still could not be avoided.
On the other hand, if international considerations permit, it is possible that the economy can continue to grow but at a sufficiently moderate pace that it will be quite some time before inflationary pressures -- real ones, not just expectations -- would force the Fed to clamp down hard. The expansion this month became the longest in peacetime since World War II. One reason that it has lasted so long was a policy change engineered by Volcker that caused the Fed to seek growth of current-dollar GNP sufficiently low to prevent the buildup of the kinds of pressures on productive capacity and wages that usually lead to a recession.
About the only developments that are making the Fed's life any easier at this point are that inflation seems to be settling down again after increasing in the first half of the year, and that the federal budget deficit has come down sharply this year.
The reduction in the unified deficit probably is $60 billion or more. Once some accounting gimmicks are removed -- they have no economic significance -- the actual reduction is probably on the order of $40 billion, or about 1 percent of GNP. That is a substantial improvement for one year, albeit as measured from the largest deficit in history. Chances are there will be a further reduction on the order of about $20 billion in fiscal 1988, assuming the economic expansion does not come to a halt.
Reducing the federal deficit is important because a smaller part of U.S. savings is needed to finance it. All other things being equal, that means there is less need to import capital from abroad to finance the government deficit and private investment.
As for inflation, the producer price index for finished goods was unchanged in August. If volatile food and energy prices are excluded, the index was up 2.5 percent in the past 12 months. That 12-month change is not very different from that experienced in much of 1985 and 1986.
The consumer price index went up 0.2 percent in July, the latest figure available. If food and energy prices are excluded from that index, prices have gone up at a 4.5 percent rate so far this year, up from 3.7 percent last year. However, the rate of change recently has been lower than 4.5 percent, and a number of analysts expect it to run at between 3 percent and 4 percent for the rest of the year.
Fed officials are troubled by the bond market's willingness to ignore the recent very good inflation figures, but that market reaction was taken as another sign of how entrenched higher inflationary expectations have become.
Still, Fed officials are not willing to say the market participants are entirely wrong. The difference between having a generally benign reading on inflation and some very worrisome signs of an acceleration may be as short as two months, according to one policymaker. Besides, there have been many examples in the last couple of decades when the Fed and its foreign counterparts came up with too little too late in response to rising inflation.
Waiting to fire until the whites of the enemy's eyes are in sight is not the battle plan at the Fed these days. On the other hand, the international mess the United States has gotten itself into could force the Fed to fire before the enemy even gets started up the hill