Now the Fed Harps on Upside Risks

No, Greenspan & Co. aren't about to tighten, but the latest comments mark a departure from recent balanced-risk remarks.
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JACKSON HOLE, Wyo. -- Sanity prevails.

The single most important two-liner in


testimony is this one:

Our economy has weathered weakness in foreign economies and worsening conditions in global financial markets with remarkable resilience, though some yield and bid-asked spreads still reflect a hesitancy on the part of market participants to take on risk. The Federal Reserve must continue to evaluate, among other issues, whether the full extent of the policy easings undertaken last fall to address the seizing-up of financial markets remains appropriate as those disturbances abate.

Obfuscation?! Not here. Whether the "full extent" of the easings "remains" appropriate?! An azure sky of deepest summer isn't clearer.

Stop all the clocks, cut off the telephone; pay no mind to those who claim otherwise. That sentence says one thing, and one thing only: If the economy continues to grow as quickly as it has during the past five months, then the Fed will (all else equal) think hard about reversing some of that easing.

This is not news to anyone who picked up on the

fact that the following two-liner was the most important piece of Greenspan's Jan. 20


Some moderation in economic growth, however, might be required to sustain the expansion. Through the end of 1998, the economy continued to grow more rapidly than can be currently accommodated on an ongoing basis, even with higher, technology-driven productivity growth.

But, judging from today's market reactions, hardly anyone did.

As to Tuesday's testimony: Filled as it was with buts and howevers, it did emphasize upside risks over downside ones. This shines through in the


revised estimate of 1999 growth.

And what a refreshing departure it is.

More than halfway through 1996, the Fed reckoned gross domestic product would grow no more than 3.0% for the year. It ended up growing 3.9%.

At the beginning of 1997, the Fed reckoned gross domestic product would grow no more than 2.5% for the year; by July, economic strength forced it to bump up its estimate to 3.5%. GDP ended up rising 3.8%.

At the beginning of 1998, the Fed reckoned gross domestic product would grow no more than 3.0% for the year; by July, the estimate had risen to 3.25%. GDP ended up rising 4.1%.

More than halfway through 1998, the Fed reckoned gross domestic product would grow no more than 3.0% this year. So now, to see that it has


that ceiling to 3.5% is telling indeed -- especially because the new estimate takes into account Russia, Brazil/Latin America, and a deceleration in European growth. Gone is that can't-remain-an-oasis thing. Here, finally, is the likely-to-continue-to-surprise-on-the-upside thing.

And now a stroll through the testimony.

The robust increase of production has been using up our nation's spare labor resources, suggesting that recent strong growth in spending cannot continue without a pickup in inflation unless labor productivity growth increases significantly further.

This means that a huge onus now rests on the productivity (and labor-cost) numbers. Greenspan's favorite

data in this area show that productivity was rising at a 2.8% year-on-year rate (and that unit labor costs were rising at a 1.5% rate) as of the third quarter of 1998. Fourth-quarter data will be released on March 9; this column has

recently discussed the productivity issue.

Equity prices are high enough to raise questions about whether shares are overvalued.

This means that Mr. Greenspan does not share

Mr. Cramer's

enthusiasm for shares.

That the inflation rate has not accelerated in recent years has been the result of a combination of special one-time factors holding down prices and more lasting changes in the processes determining inflation. Among the temporary factors, the sizable declines in the prices of oil, other internationally traded commodities, and other imports contributed directly to holding down inflation last year, and also indirectly by reducing inflation expectations. But these prices are not likely to fall further, and they could begin to rise as some Asian economies revive and the effects of the net depreciation of the dollar since mid-summer are felt more strongly.

This means that the kind inflation numbers we have seen over the past few years owe much to special factors, and that most of the help from these factors has now run its course. This column has recently addressed this issue in


recent pieces.

At the same time, however, recent experience does seem to suggest that the economy has become less inflation-prone than in the past, so that the chances of an inflationary breakout arguably are, at least for now, less than they would have been under similar conditions in earlier cycles.

This means that no, the inflation rate is not going to shoot to 5% by the end of the year. But the Fed is factoring in a rate as big as 2.5%.

Starting in 1993, capital investment, especially in high-tech equipment, rose sharply beyond normal cyclical experience, apparently the result of expected increases in rates of return on the new investment¿The surge in investment not only has restrained costs, it has also increased industrial capacity faster than factory output has risen. The resulting slack in product markets has put greater competitive pressure on businesses to hold down prices, despite taut labor markets.

This gets at the excess capacity problem -- and the effect it has had on wage growth. This column first looked at this issue back in

November, and recent numbers were

discussed about a week ago. A piece that appears

today touches on the relationship between capacity, wages and inflation.

We cannot judge with precision how much further the number of potential workers in the economy can decline without sparking ever greater upward pressures on wages and prices. But, should labor market conditions continue to tighten, there has to be some point at which the rise in nominal wages will start increasingly outpacing the gains in labor productivity, and prices inevitably will begin to accelerate.

This means that monthly employment increases in the neighborhood of 200K will eventually cause trouble. Productivity may be rising at a 2.8% year-on-year rate, but the

employment cost index

measure of wages and salaries is

growing at a 3.7% rate, the

employment report

measure of average hourly earnings is

growing at a 4.0% rate, and Greenspan's preferred measure of hourly compensation is

growing at a 4.3% rate. The "outpacing" G mentions has already begun.

In short -- no, the Fed is hardly set to tighten. But this testimony marks a notable shift to emphasizing upside risks from noting balanced ones, and it says that Fed members are currently even less likely to ease -- especially in the absence of another crisis.

Side Dish

Not even 20%? Oh sheesh -- I was hoping for a better


showing than that.

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