The financial community cheered last week when the Federal Reserve System lowered its target for short-term interest rates by a quarter point to 5.5 percent. The shout went up: "The Fed has eased! The Fed has eased!" Stocks, bonds and the dollar all rose. The spirit of Christmas seemed to suffuse the corner of Broad and Wall streets in lower Manhattan.
The celebration was premature. The U.S. economy remains on track for a recession - just before, during or just after the 1996 presidential election. Tight money appears to be the major factor in this gloomy outlook. The central bank's move last week was likely too little and too late to produce a meaningful relaxation of monetary policy.Indeed, the previous action by the Fed last summer to cut its rate target from 6 percent to 5.75 percent led to tighter, not easier, money. The money managers' specific target is the rate on overnight loans of bank reserves, the raw material for the money supply. Demand for reserves has dropped in recent months.
To keep the price of bank reserves unchanged at 5 3/4 percent, the Fed has had to reduce their supply. Total reserves fell at an annual rate of 7.3 percent in the fourth quarter (one of the sharpest quarterly contractions on record) compared with a 1.2 percent rate of decline during the summer months.
Concurrently, a record surplus in the U.S. Treasury's primary budget (revenues minus outlays except net interest payments) has already produced substantial fiscal drag - political maundering about a balanced budget by the year 2002 notwithstanding. A primary budget surplus has preceded every single business downturn in the last half-century.
Small and newly-formed business firms, which create the vast majority of new jobs in the United States, face a severe profit squeeze. In 1995, reduced profit margins in small business contributed to a sharp cut job growth. The number of nonfarm jobs rose 1.7 million in the year ended November, down from 3.6 million the year before. The number of full-time workers went up 763,000 compared to 3.2 million in 1994.
The fact that the number of jobs increased more than the number of workers showed that people were taking second and third part-time jobs to maintain family incomes. Such patterns are typical symptoms of weaker demand for labor.
Slower growth in employment added to the drag from the massive tax increase that President Clinton sponsored in 1993. After-tax personal income, adjusted for inflation, rose at an annual rate of 2.2 percent during the first nine months of 1995, down from 4.2 percent in the year before. This is the main reason why holiday sales were lethargic this year and retailers were forced to offer deep discounts well before Christmas.
Sluggish consumer spending, in turn, has had a ripple effect on manufacturing. The gross value of industrial output rose at a rate of 0.6 percent from December 1994 through November 1995. From November 1993 through
December 1994, output increased at a rate of 5.5 percent. Production of business equipment, a good proxy for capital goods spending, rose 4 percent down from 11 percent in the earlier period.
Over time, tight money will reduce the risk of inflation and help to lower interest rates. However, if the Federal Reserve pursues a policy that pushes the economy into a recession, its action will eventually lead to
pressure for reflation from the White House, Congress and the nation. Sooner or later, monetary policy that is too tight will beget policy that is too easy, just as policy that is too easy will lead to policies that are too tight.
Some Fed officials are beginning to worry that they are once again falling into the trap of go-stop-go. For example, in mid-November, Governor Lawrence B. Lindsey voted against a decision to leave the Fed's rate target at 5.75 percent. Mr. Lindsey said he dissented because he believed monetary policy should be eased.
According to the minutes of the Federal Open Market Committee meeting on Nov. 15, the evidence suggested to Gov. Lindsey "that in the absence of an easing move the underlying rate of nominal GDP growth was likely to be lower than needed to maintain real GDP at or near its potential." Translated from the jargon, Gov. Lindsey seems worried that the Fed may starve the economy of the essential supply of money.
Governor Lindsey added several caveats about the economic outlook. One, ''household balance sheets seemed unlikely to sustain the current rate of durables expenditure for any extended period." Translation: Consumer purchases of autos, appliances, furniture and other durables appear to have peaked and may well decline in the months ahead.
Two, "government expenditures were certain to be cut substantially." Three, "with fiscal contractions under way in Europe and Canada and severe
financial stresses present in Japan and Mexico," he did not see much likelihood of a substantial expansion of exports.
President Clinton may have handed Fed Chairman Alan Greenspan an unintended reason to keep the central bank close to the monetary brake. Mr. Greenspan's term as chairman expires March 2 and that of vice chairman Alan S. Blinder runs out Jan. 31. In addition, there is a vacancy due to the resignation of former Governor John P. LaWare on April 30.
Most people think Mr. Clinton will reappoint Mr. Greenspan, but the White House has not confirmed this speculation. Zero inflation is Mr. Greenspan's personal priority. With uncertainty about who will be in charge at the Fed, Mr. Greenspan has no incentive to gamble by easing policy prematurely. Ironically, that may well increase the risk of overkill, which could trigger another round of stop and go policy.