Federal Reserve Board Governor John P. LaWare, 65, was appointed to a full 14-year term by President George Bush in August 1988. Unlike most members of the board, LaWare is not a professional economist. he holds a BA in biology from Harvard University, and an MA in political science from the University of Pennsylvania. Before coming to the Fed, LaWare was chairman and a director of Shawmut National Corp., a super-regional bank holding company based in Boston. He began his banking career with Chemical Bank in New York, where he worked for 25 years.
In his public life, LaWare has carved out a reputation as a tough advocate of legislation that would allow banks to affiliate with securities firms and other financial firms. He says that banks are losing retail business to other financial competitors and facing challenges from larger foreign banks with powers that U.S. banks lack.
In an interview last week with senior reporter Stephen A. Davies, LaWare said he believes inflationary pressures have stabilized after the unsettling government reports that rocked the bond market this year. He predicted that consumer prices could rise about 2.8% this year, just under last year's 2.9% gain. while conceding that the economic outlook for the second half of the year is uncertain, LaWare said it is possible that growth could still hit the 3% mark contained in the Fed's revised annual forecast released in July.
LaWare also said the ongoing stampeded by investors to stock and bond funds from low-yielding bank accounts has some Fed policymakers worried. The flight to the funds is contributing to the run-up in prices and bears watching, he said, but the central bank still has the tools to respond to any downturn in the financial markets.
Q: The inflation picture seems to have improved lately, don't you think?
A: I think that's right. I don't see any of the classic pressures on inflation that would seem to indicate that it was going to reverse course and go up. I'm disappointed that in the first few months of the year we had some alarming aberrations, but I think they were aberrations rather than any kind of a trend line. My own guess is that maybe we'll be up 2.8% or something like that for the year.
Q: What factors are behind the improvement from the darker picture that prevailed early in the year?
A: First of all, I think food prices have not been as big a problem. Energy prices have actually come down. Wage settlements seem to be in a range that is not threatening. From the information we can get from the private sector, salary adjustments for individuals are not inflationary. And the auto industry has not been as aggressive in moving pricer, up behind the German and Japanese prices that have been at least partially driven up by exchange rates. So some of the things that normally contribute to an inflationary spiral are not there. And certainly land and housing prices have moderated.
Q: Economic growth was slow during the first half of the year, but inflation statistics were worrisome. What do you think was going on?
A: I don't really know. We had a bulge in food prices that I think was a contributing factor, and there may have been some selective price increases based on what we know was a pretty strong fourth quarter. Maybe people thought here was an opportunity to get in first with some price adjustments. And I don't think anyone expected the pace of the economic expansion to change as dramatically as it did from the fourth quarter to the first quarter.
Part of the fourth-quarter phenomenon, I think it's probably fair to say, was the psychological impact of the election, and the general feeling that a more activist administration was going to attack economic problems. To some extent that may have flipped, as people began to come alert to the fact that there were going to be significant tax increases, that cutbacks in government spending were going to cost jobs. that the re-engineering of American businesses was going to continue. Even some of the untouchables like IBM and others were significantly laying off people, and almost every day when you pick up the newspaper you see yet another company announcing major cutbacks. Well, if you are uncertain about the impact of taxes. you don't know how this omnibus health-care thing is going to affect you from a personal point of you. And you're less secure in your job no matter how good you are -- because CEOs are as frequent casualties today as the guy on the production line. That combination of things makes people cautious about taking on large longer-term commitments. And I think that's part of the reason that in spite of almost unprecedented low interest rates in the mortgage market that we have not seen a bigger spurt in housing, which traditionally is one of the leaders in a recovery period.
Q: The Fed's own forecast calls for economic growth in excess of 3% in the second half Do you think we'll get that?
A: Oh gosh, I don't know, it's very hard to tell. You know the signals are so damn mixed. I think it's certainly very achievable. We're three weeks away from having a clearer idea of what the third quarter would be. I would expect the third quarter and the fourth quarter to be significantly stronger than the first and second, but whether we get to a 3% level is hard to predict, for me at least. not being an economist.
Q: The August employment report looked so bad that some said the Fed
A: I think [Fed Vice Chairman David] Mullins said it very well when he said that at the very best, any kind of a reduction in rates would have a very marginal effect, if any at all. I happen to be one of those who believe it wouldn't. We already have negative short-term rates, and making it a little bit more negative, it seems to me, is not going to get much of a result.
A: Okay, but look at bank interest rates. A lot of these banks are paying 1 1/2%, less than 2%, on their money market demand accounts, so those people are getting a negative return.
Q: Are you impressed by the President's deficit reduction program, and how much do you think that's helping to lower interest rates?
A: To the extent that you have confidence that the spending cuts that have been put into the program are actually going to happen, then you have to feel that some real progress will be made on the deficit. But I guess I'm so cynical based on previous agreements -- the repeated violations and desertions of Gramm-Rudman and the failure of the 1990 agreement to achieve the spending cuts that were promised -- that I'm skeptical about that side of it. The other side gets cast into law and the taxes get collected.
Q: Do you think the package has had a role in lowering long-term rates?
A: I think there's been some of that. I think inflation expectations have been cooled. first by recent performance in the inflation numbers. and second by expectations that further increases in deficit spending won't be contributing factors. And I suspect to some extent by the chairman's Humphrey-Hawkins testimony to the effect that we're prepared to cut any trend in that direction off at the pass.
There's also a demand phenomenon. We've had huge migrations of funds out of transaction accounts into investment accounts. Somebody told me the other day that mutual funds are growing by something like $1 billion a day. That need to put the money to work creates demand in the bond market and the stock market that must have some effect on the pricing structure. And mutual funds, into which much of this money is pouring, are reaching out internationally more aggressively than they have before ... with the full realization that many of these countries into which these foreign investments are going are not doing very well right now .... Several of these large fund-managing outfits are creating new foreign funds on a fairly aggressive basis. If you accept the fact that they may be seeing opportunities to buy toward the bottoms of some of these markets, [that's one thing,] but if you're buying into a sloppy economy, that's another. The German stock market has been up until the last couple of days in spite of the fact that the German economy is kind of sick. And while the Nikkei is less than half of where it was just three years ago, it's still a fairly high multiple in terms of the profit-earnings ratio. It makes our [market] look conservative, and ours doesn't look conservative by our own experience.
Q: You seem to be raising two concerns. One, that financial markets might be getting overpriced, and two, that a lot of money is flowing is out of bank accounts.
A: I don't know if they are concerns, I just think that's part of the explanation. The banks don't have a significant amount of loan demand, so they are not aggressively bidding for deposits and have reduced the rates they will pay on money market demand accounts. Consumers are desperate for return so they're reducing balances in transaction accounts and putting them elsewhere. They've drawn down small-time deposits as well. So the money market funds are not going to turn this stuff away. They have to put it to work, so they go into the market and try to buy something. Unless the laws of supply and demand have changed pretty radically, that full increase in demand has not been matched by new issues and so forth, and so it has tended to lift all the boats in the harbor.
Q: Meaning prices?
A: Yes.
Q: Well, suppose people stopped pouring money into these funds?
A: That'll change the growth rate of the funds and the demand for new investments, but those funds have been in a stable environment before. It will cut down trading volume in the bond and stock markets, much to the displeasure of the brokers and dealers, but I don't see any particular danger in that kind of thing.
Q: Is there a situation of financial excess building up here that you think might be worrisome?
A: Well, I must say that some of my colleagues are concerned about that, and you could build a scenario of a bubble building. I'm not sure I see that yet, but it's certainly something that everybody wants to keep their eye on.
Q: Do you think the Fed still has the tools to handle any financial crisis that might come up, such as flight by small investors out of these stock and bond funds?
A: Oh, I think so. I don't see any change in the structure of the markets that is so significant that it would change our ability to respond to some sort of crisis that would develop. But you can't make a 100% statement on that, because every hiccup has a different characteristic to it.
Q: What would the Fed do in a situation like that?
A: Take two and hit to right. That's a flip way of saying it, but it's like a battle. You have to change your tactics to meet the current situation, and it's impossible to know in advance just exactly what that situation would be.
