Q: How strong is the economy, in your opinion?
A: This is a very difficult period in which to make a firm judgment. We are seeing some rather clear sign that growth is slowing in a number of areas .... But if you look back at the history of expansion over the postwar period, you often find periods of temporary slowdown that are followed by a resumption of much stronger economic growth. I think at a time like this you need to go back and look at the fundamentals, which to me still look quite strong.
Consumer are quite confident even though we had a slight slip of consumer confidence in May. Their financial balance sheets are in pretty good shape, and employment gains have strengthened this year despite the small increase in payroll employment in May. So the consumer sector should continue to move forward - not as fast perhaps as it has, but at a pretty good clip.
Housing is less affordable today than it was last fall, but still quite affordable by standards of the past 20 years. Housing isn't going to collapse at today's mortgage interest rates. Business fixed investment - the durable equipment component of that has been by far the major source of stimulus to the economy during this recovery - shows no signs of slowing down at all. And now we have every indication that investment in structures is beginning to pick up again. Inventories are in absolutely great shape.
Finally, the external sector continues to be a drag on the economy, but we keep reading more every day about improving economic activity in Western Europe and maybe even the beginnings of an upturn in Japan. So it seems to me that the external sector is going to be less of a drag on overall growth as the year goes on.
Q: What kind of growth are you looking for in the U.S. economy this year?
A: My number is around 3.25%, fourth quarter to fourth quarter. I would have a higher number but for the fact that I assume further measures of Federal Reserves tightening designed very deliberately to cool off the economy in order to keep inflation from worsening.
Q: A lot of analyst see some sign of cooling in the economy and believe that the Fed may pause for a long time or may only tighten credit one more time this year. Do you share that view?
A: I think the Fed officials were signaling with their May 17 press release that they wanted to give the market a respite from further tightening actions, and that will last as long as the Fed safely thinks it can. I do not expect any tightening action by the Fed at its next [Federal Open Market Committee] meeting, which is July 5, but my guess is that the respite isn't going to last a lot longer than that. I think that by the August meeting, we're likely to see signs that the economy's growth is beginning to pick up again, and so the end of Fed tightening is not yet here.
Q: How much more Fed tightening do you think we're going to see?
A: This is the toughest question that anybody can pose. I don't think anybody has an ability to make a judgment on that without acknowledging at the outset that he's licking his finger and sticking it in the air, which is what I'm doing. I think the fed funds rate is probably going to have to go up to somewhat over 5% by early next year to get growth slowed down to around 2.5%, which is about our long-term growth potential, and to keep it there in the face of what probably will be increased strength from the external side during the course of 1995.
Q: Do you think the Fed's rate hikes so far this year are starting to bite?
A: Sure, they're having some effect. But I would say the principal reasons for the slowdown in the economy are probably not that, because the effects of higher interest rates take a while to register themselves in economic statistics and the course of the economy. But in the housing area particularly, you see some advance indications that monetary policy is indeed working. Refinancings have dropped off a ton, and this is important because it will slow a source of cash to consumers. We are also seeing in our weekly survey of applications for loans received by large mortgage bankers a rather significant decline for loans to purchase houses.
Q: If you're assuming growth of about 3.25% this year, then you must see some slowing of economic activity in the second half.
A: I do, indeed. I think the third quarter is likely to be a 3% to 3.5% quarter, which will be held up by some degree to a rebound in auto production, which is declining on a seasonally adjusted basis in the second quarter largely because capacity limits are preventing the usual seasonal rise from taking place.
So inventories are being drawn down and manufacturers will produce more than they do in the summer period, and that will tend to hold the growth of GDP. But if the Fed keeps moving towards restraint, as I expect them to, then I would anticipate the impact of higher interest rates to begin showing some clear effects on monthly numbers in areas like housing starts and building permits later this summer and a reduction in GDP growth to around 2.5% - maybe a little more - in the fourth quarter.
Q: There doesn't seem to be much doubt in your mind that the Fed is in effect targeting growth and trying to steer the economy into a slower growth channel in the range of 2.5%.
A: There isn't any doubt in my mind that they're trying to slow the economy down to our long-term growth potential, but the 2.5% is my number, not theirs. But if you read the policy records and published statements of Federal Reserve officials, there's not much doubt that their major concern is that if the economy continues to grow at a pace well above our long-term growth potential, then worse inflation becomes almost inevitable. So yes, that is what I think they're aiming at.
Q: President Clinton recently said in an interview on ABC that he would like to see the Fed hold rates steady for the rest of the year as long as there is no evidence of a pickup in inflation. Do you think he'll get his wish?
A: No. My guess is that the Fed will tighten monetary policy further. The argument that the Fed should hold still until inflation begins to rear its ugly head is badly mistaken. Monetary policy works on the economy with a considerable lag, and on wages and prices with an even longer lag. If the Fed waits until inflation becomes evident, even tot he politicos in the White House, it is way too late.
Q: Greenspan has said he is aiming at 1995 in what he is doing, so his actions in raising rates have been called a preemptive strike against inflation. Do you think he'll be successful?
A: I don't suppose that the Fed will be so successful that we have absolutely no increase in inflation in 1995. But I think they will succeed to the degree that will keep the worsening in inflation in 1995 down to quite moderate proportions. If they do that, then we'll end up this expansion with an inflation rate that was considerably lower than the one we ended up with at the end of the expansion in the 1980s. And that will be a very substantial degree of success.
Q: What kind of inflation are we looking at?
A: My number for the [consumer price index] in 1994 is 2.9%. My number for 1995 is 3.3%. That's what I would call a very modest uptick.
Q: What's your outlook for long-term bond rates this year and next?
A: I think as short-term interest rates go up, so also will long-term rates, but not as much. I think we'll see a reversion to more normal historical patterns in this respect, and therefore some flattening of the yield curve. I would anticipate that we will see a 30-year Treasury bond a little over 8% by early next year. And if the Fed succeeds in avoiding any worse numbers on inflation that I have used. then that's going to be the peak on long-term bond rates for this cycle - 8% to 8.5%, somewhere along in there.
Q: Do you think this Fed tightening can actually succeed in prolonging the expansion throughout Clinton's first term and ultimately help him?
A: Yes, I certainly do. Let me put it to you another way. If the Fed had sat idly by and let the funds rate sit at 3%, then by the middle of 1995 we would have had a roaring inflation, and they would have had to clamp down harshly, and the chances of recovery continuing through 1996 would have been minimal.
I think there's every reason to be optimistic that if the Fed stays ahead of the curve, as I think they will, we won't have an economy that is severely weakened by sharply higher interest rates next year.
