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Jewish World Review May 26, 2000 / 21 Iyar, 5760

Mort Zuckerman

Mort Zuckerman
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Is the Federal Reserve trigger-happy?

http://www.jewishworldreview.com -- ON THE VERY DAY that the Fed put through the largest interest rate increase in five years to contain inflation, it was reported that last month's consumer price index did not move at all.

Well, the Fed governors are not quite shooting at shadows. Before this month, virtually every important measure of inflation had been moving upward. An unsustainable rate of growth will produce inflation over time, and the Fed believes that a sustainable growth rate is below the 7 percent-plus rate of the last quarter of 1999 and below the 5.4 percent of the first three months of 2000. A wage-price cycle is the worry. The unemployment rate has a 3 in front of it, bringing us the lowest peacetime unemployment rate since 1957. A record 65 percent of Americans ages 16 and over are now employed, the highest in history. Every measure of joblessness, including unemployment for minorities, is at record lows. It is not surprising that wage and benefit costs are rising, the former at over 4 percent annually and the latter at 5 percent annually (especially health benefits, which have been rising at even higher rates), more than doubling the rate of last year.

The Fed has another concern. The exploding stock market has created a "wealth effect," the feeling of being better off on paper that adds to the very strong demand for consumer goods and services that cannot be satisfied without generating inflation. Americans are spending an increasing proportion of their disposable incomes, now up to 99 percent, in part because the stock, real-estate, and job markets have bolstered both wealth and confidence.

Investment boom. There is still no firm evidence that inflation has taken root. Most of the inflation indexes remain well in check. They have gone up by only about a half of a percent above the unusually low rates of the last couple of years, which were a function of the collapse in oil prices and the crises in Asia and in Russia. In fact, unit labor costs remain well below inflation rates, rising under 1 percent in the last year because we have seen extraordinary gains in productivity. The gains are averaging about 3 percent–nearly three times the level of the 1970s and 1980s, and this achievement has contributed to the noninflationary growth of the past several years.

So is the economy so good that it is bad? Our growth has by and large been led by an investment boom. It is this boom that has given us the benefits in productivity so that we have been able to grow faster without inflation–but being able to drive faster doesn't mean that it is safe to drive at any speed. The critical "cruise control" challenge for the Fed is to balance monetary policy against the desire to sustain the investment boom, especially in technology in order not to sacrifice the productivity gains it has given us. In other words, there may not be a new economy, but there is a new business cycle driven by investment in information technology, which now accounts for about a third of economic growth. This is an industry that pays good wages and yet, simultaneously, pro- duces falling prices–and the spread of technology cuts across the whole American economy, boosting productivity, reducing costs, cutting inventories, and facilitating electronic commerce.

High-tech has replaced the traditional cyclical activities of the old economy as the engine of growth. In the old economy, prices would rise and productivity growth would slow as factories hit their capacity limits. In our new high-tech world, there is a big upfront investment but then the unit costs of production are relatively low and they keep falling as demand increases, so that price decreases offset wage pressures. All this suggests that the Fed has not acted too soon. The decline in inflationary expectations in 1998 and 1999 that accompanied the energy-led drop in consumer inflation, which enabled workers to enjoy increased real wages and thus accept pay constraints, is behind us. The world economy is in a synchronized upturn. But the picture is nonetheless mixed. Oil prices have peaked, and other industrial commodity prices remain stable; the dollar is strong, which makes imports cheaper; and the Dow and Nasdaq averages have fallen, thus diminishing the so-called wealth effect.

The Fed hopes that higher interest rates will contain consumer spending and reduce inflationary pressures. The danger is in overreacting to a month or two of economic figures and killing the investment boom that has brought us so much prosperity in recent years. The Fed must move cautiously now to make sure it hits the real target, inflation, and not the wrong target, investment and productivity.



JWR contributor Mort Zuckerman is editor-in-chief and publisher of U.S. News and World Report. Send your comments to him by clicking here.

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© 2000, Mortimer Zuckerman