Once Again, Fed Walks a Tightrope

Production figures and reports from purchasing managers in recent months suggest that real gross national product are expanding in the present quarter, stimulated by recovery at the nation's factories.

How rapid and well sustained the recovery will be is not yet knowable. And that, of course, poses a problem for policy authorities, particularly the Federal Reserve.

The Fed must assess not only the recovery's internal dynamics, to determine whether policy should push harder, but also how much the recovery may be advanced or retarded by foreign authorities' policies.

Inventories and Demand

From an internal perspective, the early stage of recovery will apparently be fueled mostly by a slowdown in inventory liquidation. Final buying of goods and services by U.S. customers, which picked up in the second quarter, seems from all reports to have been in the doldrums much of the summer.

A key question for policymakers is whether an initial expansion in real GNP that is strongly dependent on inventory turnaround would generate enough follow-through to galvanize the recovery. If they think not, it would be very tempting - even necessary - to reduce U.S. interest rates further, ensuring sufficient spending to justify the upsurge in factory production.

If, as seems likely, depository institutions have more stringent credit terms than usual for this stage of a business cycle, it is even more urgent for the Fed to work toward lower open market interest rates.

Recent sluggishness in growth of the relatively broad monetary aggregate, M2, indicates continued stringency in policy.

However, strength in the narrow transactions aggregate, M1, shows that the Fed has been rather aggressively providing reserves to the banking system in an effort to reduce rates.

Whether the Fed's policymakers have done enough is debatable. Maybe they have not, but there is a lot to be said for patience and caution.

Upward Pressure

A rapid expansion of domestic spending carries a high risk of generating interest rate increases several months or so down the road that would abort the transformation of recovery into sustainable expansion.

The basic reason is that such an expansion would again raise the specter of a domestic savings shortage.

Such a shortage would hurt much less if inflows of foreign savings compensated, as they did in the 1980s.

The United States is still a very attractive investment arena for foreigners, especially when political conditions elsewhere are unsettled.

But net foreign savings available for investment in the United States have declined, largely because foreigners are diverting savings to their own uses. Germany is the most obvious example.

In the past year, the United States had less need for foreign savings, because of the recession.

As we come out of recession, that need will rise if domestic spending expands significantly. The need could well go unrequited if it gets too large and accompanies an export surge.

The Outlook for Exports

Because of the increased competitiveness of U.S. industry, substantial further export gains are probable once it proves practical for countries like Germany and Japan to ease their strong monetary restraints (stronger in Germany than in Japan, which has already eased a bit). Such restraints, along with U.S. monetary caution, are keeping inflation in check at the short-term cost of limiting world growth.

In the intermediate term, our economy cannot sustain both an export surge and a strong rise in domestic spending. There are just not enough private savings to support both (particularly since the federal deficit is unlikely to decline much until after the next fiscal year). Nor would inflation remain restrained.

Indeed, it would be best all around for U.S. domestic spending to rise only quite modestly.

Central Banks' Stance

If foreign central banks would ease sooner rather than later, the Fed would have a better idea how strong our international sector might be and, thus, how much additional encouragement need be given purely domestic sectors.

However, Germany and Japan are experiencing as much inflationary pressure as the United States, or more. As a result, they would rather ease slowly, if at all.

All of this leaves the Fed with a dilemma:

It can ease now, risking high interest rates later if both exports and domestic spending rise.

Or it can hold policy steady, risking a decline in output growth if domestic spending does not pick up on its own this fall or if key foreign central banks maintain tight monetary policies.

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