The fixed-income market's decline and upward adjustment of interest rates after the July 19 testimony of Fed Chairman Alan Greenspan was long past due.
He dispelled the widely held view that the economy is on a downward spiral that would require further easing on the part of the Federal Reserve. Quite the contrary, he projected renewed growth in the second half of 1995 and throughout 1996.
The testimony removed the last vestige of hope among the economy bears and bond market bulls, who were already confronted by a growing body of data consistent with renewed economic growth.
Adding to bond market bearishness was the burden of new supply in the form of forthcoming Treasury offerings plus a large volume of corporate and municipal debt issuance.
Finally, a stable dollar removes the prospect of foreign central bank purchases of government securities.
Each was sufficient grounds for the upward adjustment of rates; in combination, they made a powerful force.
Chairman Greenspan went to some length to specify the areas of existing and prospective strength in the economy, projecting fourth-quarter-over- fourth-quarter increases in real gross domestic product of 1.5% to 2% in 1995 and 2.25% to 2.75% in 1996.
We are in complete accord with the chairman's specific analysis, but conclude that growth will be stronger throughout the forecast period.
If the Fed's forecast is correct, the economy will grow at a sustainable rate with benign effects on inflation. If we are correct and the economy grows a little faster, inflationary pressures are likely to reappear in 1996, especially in the second half.
Bear in mind that the reacceleration is taking place on a high base of resource utilization. That is to say, the unemployment rate was last reported at 5.6%, which is relatively low, and capacity utilization was last reported at 83.5%, relatively high.
Also bear in mind that for 1992-94 the Fed underestimated the economy's vigor.
We believe the Fed is still underestimating, but not by as wide a margin. Inflation has been moderate, an extraordinary performance in the fifth year of an expansion. Moreover, the economy's slowing in the first half of 1995, we believe, broke the momentum of rising prices and the psychology of inevitability. The benefits of that slowing, in terms of suppressed inflation, are still in front of us.
Nevertheless, if by the second half of 1996 the rate of economic growth exceeds the sustainable rate, as we think likely, inflationary pressures are likely to reemerge. Thus, we anticipate renewed Federal Reserve tightening in 1996.
In our view, the increased issuance of private-sector bonds will continue throughout the second half of 1995. Favorable economic prospects and relatively low intermediate and long-term bond yields are likely to induce businesses to restructure balance sheets with more permanent financing after 18 months of heavy reliance on short-term borrowings from banks and the commercial paper market.
Finally, a more stable dollar should reduce or eliminate the need for foreign central bank currency market intervention. In the first half of the year, their purchases of Treasury securities totaled an estimated $45 billion to $50 billion (actual, not at an annual rate). That support for the Treasury market will simply not persist.
The implications are clear: No Federal Reserve easing equals upward pressure on interest rates.
Mr. Sherman is director of research for the New York investment banking firm M.A. Schapiro & Co.