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Why the Fed Can't Move

It feels like the best of times right now. The stock market's hot, inflation's not and corporate profits continue to motor ahead.

But can this continue indefinitely? Is the Dow headed for 10,000? Are long-term rates destined to fall further? When will it all end? These are all items on the

Fed

docket as the

Federal Open Market Committee

gets ready to meet Tuesday.

There doesn't appear to be any dispute about the U.S. economy's strength. Gross domestic product grew at a rate of 2.0% in 1995, 2.8% in 1996 and more than 3% in 1997. GDP accelerated to better than 4% in the fourth quarter of last year. Housing activity is brisk, the unemployment rate is low and new jobs are coming on line at a heady pace.

As the economy races ahead, what of inflation? Looking at the money supply, monetarists can find little comfort. The two most closely watched barometers of money growth, M2 and M3, were increasing at rates above the limit of the range set by the Fed (1% to 5% for M2, 2% to 6% for M3.) The growth rate of M2 is about 7% and M3's growth is close to 11%. With the economy pretty strong and money supply expanding swiftly, one might readily conclude that the Fed will increase short-term rates. But despite that logic, few expect that Fed to raise rates.

Those few supporting a rate hike include mostly preemptive-strike types. These inflation hawks want a sharp show of strength before inflation can get a toehold in the economy. This approach was first popularized by the

Bundesbank

, Germany's central bank, led by its chief,

Hans Tietmeyer

. In the U.S.

Alan Greenspan

has been the chief proponent of this policy. The fatal flaw of such an approach is that it presumes that increasing or decreasing rates will have only domestic consequences. That's clearly not the case.

The Fed's increase in rates last March and the subsequent increases by Western European central banks was sufficient to attract global capital that would have otherwise found its way to East Asia, thus draining them of liquidity. The West's role in the Asian disaster is now clearly understood in Washington and in other world capitals. It may never be admitted, but concern that the Asian crisis might be repeated elsewhere will most assuredly damp any enthusiasm for such a move in the foreseeable future

While horribly destabilizing, the crisis in East Asia did have a positive side, at least with respect to the U.S .economy. Without any further Fed action, economists argue that the Asian crisis will produce a slowdown in aggregate U.S. demand. And, as demand slows, inflationary pressures are likely to ease.

Also arguing against a rate move: the

European Monetary Union

, expected by January 1999. This union of 11 nations is a watershed, described by some as the most important financial event to take place since the breakdown of

Bretton Woods

in the early 1970s. EMU will unite the most powerful nations in Europe with a new currency, the euro. And with the euro's creation, the dollar will face real competition for the pricing of transactions. Today 80% of financial transactions and 50% of commercial transactions are priced in dollars. That will likely begin to change. The financial world maintains $1.4 trillion in reserves. How quickly and to what extent the financial world shifts from dollars to euro will have a profound effect on the relative value of the dollar and on our markets well into the future.

Of course, to bring Europe together in this fashion is a herculean task. To gain entry the participating nations had to meet certain criteria, including budget deficits of no more than 3% of GDP and public debt of less than 60% of GDP. Eleven nations now qualify. Britain, had it desired to become a member, would have qualified but opted out for the present. The U.K. can be expected to join by 2001.

The process of bringing these nations together under one currency and one rate structure is called convergence. The participants are adjusting currency values, budgets and rate structures to bring about alignment. This convergence is essentially taking place around the German rate structure. And as the euro draws nigh, European nations have agreed that between now and the implementation date, no nation would take action that might in any way destabilize this effort. For the United States to raise rates now would certainly be seen in Europe as an unfriendly act, especially since the dollar is already performing with such strength.

Despite a scorching U.S. economy, the Fed's hands are unmistakably tied. The European monetary union, a strong dollar, uncertainty in East Asia, and a stable price structure translate into a steady-as-you-go policy. For the first time since former Fed Chairman

Paul Volcker

instituted an aggressive rate policy in late 1979 to halt inflation, the U.S. is forced by circumstances beyond its control to surrender the monetary initiative.

With no prospect of a change in policy, the world's financial markets stand to be the natural beneficiaries as money flows into them unimpeded. We are not likely to hear much about inflation or irrational exuberance for the foreseeable future. No central bank is likely to take the punch bowl away from this party, at least not for now.

David Barrett, based in Darien, Conn., advises international investors about central bank policy and investing. He welcomes your

feedback.