When Federal Reserve policymakers gather next week, it's a foregone conclusion that they will raise short-term interest rates by a quarter-percentage point to keep the rapidly growing U.S. economy from eventual overheating.
Fed Chairman Alan Greenspan signaled last week in congressional testimony that a rate increase is on the way, but he left open the complex issue to be thrashed out at the June 29-30 meeting: What comes next?
Many Fed watchers, such as Bill Dudley, chief economist at Goldman Sachs Group Inc. in New York, expect Greenspan and his colleagues to agree that one small rate increase won't be enough to accomplish their goal.
"We anticipate a second tightening step in 1999, probably at the Aug. 24 FOMC meeting," Dudley said, referring to the Federal Open Market Committee, the Fed's top policymaking group. "Thereafter, Fed officials will likely step back and wait to see whether their fears that inflation will gradually rise are realized or not."
At Stone & McCarthy, a financial market research firm in Princeton, N.J., Dana Saporta, agreed.
"Greenspan has not ruled out more than one tightening," Saporta said. "Given the economic imbalances he has identified -- labor markets that are too tight, asset prices that may be too high, consumer spending that is growing too fast -- we sincerely doubt he believes just one quarter-point adjustment is going to make things right."
On the other hand, some analysts believe the Fed chairman's reference in his testimony to "modest preemptive actions" was a reassuring sign that he wants to boost rates by the usual quarter-point and then wait to see what happens. Rising interest rates tend to slow economic growth by raising borrowing costs for businesses and consumers.
But almost everyone agrees the FOMC is likely to raise its 4.75 percent target for overnight interest rates to 5 percent next week. A year ago that rate was 5.5 percent, but the central bank lowered it in three steps last fall, primarily in response to a global financial turmoil that erupted after the Russian government defaulted on part of its debt.
The open question for next week's session, which could be a contentious one, is whether Fed policymakers also will adopt a directive indicating that they are leaning in the direction of a further rate increase. The FOMC adopted such a "biased" directive at its meeting last month and, for the first time, publicly announced that they had done so.
Historically, when the FOMC has raised rates it has virtually always adopted a "neutral" directive -- meaning that a rate decrease is as likely as a rate increase. Now, with the FOMC seeking to be as open as possible about its actions by announcing changes in the directive, some members are wrestling with what sort of signal they want to send to financial markets about their future intentions.
For one thing, many forecasters -- notably some within the Fed -- are predicting that U.S. economic growth will slow in the second half of this year for a variety of reasons, including the substantial rise in recent months of long-term interest rates such as those on home mortgages. Staff economists at the San Francisco Federal Reserve Bank, for example, expect growth of about 3.25 percent for the rest of the year. That would compare with an annual rate of about 4 percent over the past three years.
At the beginning of the year, Fed officials had anticipated more of a slowing than that. That expectation coupled with a further decline in inflation were the principal reasons policymakers did not earlier seek to reverse some of last fall's rate cuts.
Greenspan said in his testimony last week that his essential concern now is that there is too much liquidity -- meaning cash -- sloshing around the economy. The ready availability of credit has helped fuel the stock market boom, and the capital gains racked up by investors in that hot market have encouraged both households and businesses to spend enough additional money to "account for at least one percentage point of gross domestic product growth over the past three years," he said. A rate increase would suck a portion of that cash out of the system and eventually slow those large increases in spending on goods and services.
The Fed chairman readily acknowledged that inflation currently is not getting worse and he sees no sign that it is about to begin even a slow upward spiral. But over the past three years, rapid economic growth has caused the jobless rate to drop to a very low level.
"Should labor markets continue to tighten, significant increases in wages, in excess of productivity growth, will inevitably emerge, absent the unlikely repeal of the law of supply and demand," Greenspan explained in his testimony. "Because monetary policy operates with a significant lag, we have to make judgments, not only about the current degree of balance in the economy, but about how the economy is likely to fare a year or more in the future under the current policy stance."
Greenspan said that while the economy has been growing at 4 percent, the working-age population has been expanding by about 1 percent a year and labor productivity -- the amount of goods and services produced each hour worked -- has increased an average of about 2 percent.
That arithmetic suggests that the Fed might be aiming to hold growth to 3 percent, but that is not necessarily the case. The Fed chairman has said repeatedly that productivity growth is still accelerating.
His warning that such an acceleration cannot continue indefinitely has been misinterpreted by some analysts as meaning that he expects productivity growth to slow. But Greenspan explained in his testimony that he does not expect recent gains to be reversed.
For instance, in 1996 through 1998, productivity of nonfinancial corporations increased an average of almost 2.8 percent annually. Over the latest four quarters -- that is, from the first three months of last year to the first three of this year -- productivity of such firms rose 3.7 percent. In the broader nonfarm business sector of the economy, the rise over the same four quarters was 2.6 percent. Forecasters expect another strong gain in productivity for the current quarter.
If productivity keeps increasing at such rates, economic growth would not have to slow very much -- if at all -- to keep labor markets from becoming even tighter. And Greenspan has given no indication that he feels the current 4.2 percent unemployment rate needs to go up to head off an increase in inflation.
Mickey Levy, chief economist for Bank of America in New York, said he expects that Greenspan's "tendency toward gradualism and consensus-building most likely will limit" next week's rate increase to a quarter-percentage point. But he also anticipates the FOMC will decide to retain the "bias" in its directive, "signifying that the probability of another tightening exceeds the chance of a reversal to easing."