Recovery likely to proceed without fear of inflation

SUNDAY OUTLOOK

April 17, 1994|By John E. Woodruff

Two increases -- totaling a half percentage point -- in the Federal Reserve Board's federal funds rate have ended a decade of loosening monetary policy and raised questions about the impact those moves will have. Must interest rates go up even more to keep inflation from surging back? If so, how far? And what will that do to the recovery?

Peter Van Dyke

Manager, fixed-income

mutual funds,

T. Rowe Price Associates Inc.

Continuing economic strength will cause the Fed to extend this gradualist policy. By the end of this year, the target for federal funds may inch up from the present 3.5 percent to perhaps 4 or 4.25 percent.

But after the drastic reactions of both the equity and the bond markets to the first two moves, another jump or two is already factored into longer-term interest rates, and they probably will trade between the present 7.25 percent and perhaps 7.75 percent the rest of the year.

So housing construction may be affected, but automobile sales and things people buy on credit cards shouldn't be.

Some people talk about choking off the recovery, but they forget how robust the economy was in the 1980s, with interest rates in the teens We'll look back in a couple years and see it was a very good thing that the Fed kept factories operating somewhat under capacity and kept a lid on inflation.

Mani Govil

Analyst and portfolio manager, Mercantile Bank and Trust

Price indexes are showing good year-over-year appreciation that shouldn't be a threat, but interest rate markets mistook the Fed's first two notches on the federal funds rate as a signal that inflation is coming back.

Whether inflation comes back will depend on a worldwide

recovery. Japan is still in limbo. Europe, where wage rates have typically driven inflation, still has massive unemployment.

For the next six months, the economy can grow with no reason to fear inflation.

Charles O. Heller

Director, Dingman Center for Entrepreneurship,

University of Maryland

My purely personal feeling is that interest rates won't go upmuch more.

When we work with small businessmen who are looking for loans, we tell them they shouldn't even think of going to a bank if they can't support interest rates of 15 to 18 percent.

So for small entrepreneurs, the difference between, say, 3 and 4 percent in the federal funds target is not critical.

In fact, it may be a blessing in disguise. For several years, the issue has not been how much interest a small businessman has to pay but just getting money at all.

Now, with a strengthening economy, higher interest rates may make it attractive to banks to lend to small businesses again, and that would actually help the economy.

Daniel Friel

Vice president and senior

economic analyst,

NationsBank

We see the U.S. economy ending the first half of 1994 at annual growth of about 4 percent. That would be stronger than the Fed would like to see, probably by a point or a point and a half, especially since the Fed was surprised by faster growth than expected for the last quarter of 1993.

You're not seeing inflation yet in the Producer Price Index or the Consumer Price Index, but if you wait for it to show up there, it's already too late.

We're looking at 83.4 percent capacity utilization in manufacturing in February, and the National Association of Purchasing Managers is reporting 63.7 percent of their people already feeling increases in parts and materials costs compared with 54.5 percent a short time ago. There are enough warning flags that if GNP growth does come in at 4 percent, it will heighten the Fed's concerns.

A further major correction in the stock market might make the Fed cautious for a time, but we should expect a federal funds rate around 4 percent by year's end.

That would be a "neutral" position -- not trying to stimulate and not trying to restrain, just trying to keep ahead of inflation. That's a change; until recently, they really had their foot slammed hard on the accelerator.

Borrowing costs will go up, but I don't see interest rates doing a lot to the economy. Even housing construction, after jumping sharply in the first half of this year, probably will grow a lot more slowly in the second half, but it should still grow.

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