Greenspan's Rates of Wrath

By John Greenwald

I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone.

--James Carville, Clinton campaign strategist

But even bullies get the blues. In fact, last week may prove that the redoubtable bond market suffers from a permanent case of existential fretting. From his temple-like headquarters in Washington, Federal Reserve Chairman Alan Greenspan offered up to traders what they had been counting on: he raised short-term interest rates on Tuesday by the largest amount since 1981. His goal was to restrain the economy and forestall inflation. If traders are convinced that inflation looms, they might dump bonds and thereby drive up the cost of the long-term loans that have financed the business recovery.

But no sooner had the Fed acted than bond investors began to worry that the 0.75% rate hike might not be enough to keep inflation at bay. "There's more to do, so what's the point in being a hero and buying bonds at this rate when it still has a way to go," said David Glen, 37, the manager of $6.5 billion in bond funds for Scudder, Stevens & Clark. So after a brief period of euphoria, the bond market tumbled.

This vote of no confidence gave the bond market the aspect of a fierce pagan idol that can never be appeased. No sooner does the market receive one form of tribute than it finds fresh problems to worry about. Among other things, investors saw a new threat of inflation in promises by House Speakerin-waiting Newt Gingrich and other Republicans to cut taxes next year without any credible program for restoring lost revenues. "Tax cuts are not always good for the bond market,"said Joseph Carballeira, the head of U.S government- securities trading at Smith Barney. "Initially, there was a sense of optimism when the Republicans won. But now there is the sense that fiscal discipline may be over." Said Hugh Johnson, chief investment strategist for First Albany: "This has become a nagging fear that bond traders have in the back of their heads. They might not discuss it much, but the fear is there."

Greenspan seemed to be striking out on two fronts: he was receiving little credit from the bond market for jacking up interest rates for the sixth time this year, and he was unintentionally deepening an old fault line in the American economy. "Never before has there been such a huge gap in perception between what is going on in the real economy and what the financial markets think is going on," says Robert Hormats, the vice chairman at Goldman Sachs International. The two sides, used to fighting with statistics, came as close as they could to meeting face to face: while Fed members deliberated last Tuesday, some 200 AFL-CIOled protesters gathered outside in the first such demonstration against rate hikes since farmers blocked the street with tractors in the early 1980s.

Less partisan Fed watchers argued that Greenspan should declare victory in the war against inflation and stop driving up rates. "Further increases on top of the one this week could absolutely push the economy into a recession," warned Lacy Hunt, chief U.S. economist of HSBC Holdings, a bank holding company. Ford chairman Alex Trotman had similar misgivings. "Another hit like this one and I start to get concerned," said Trotman, who learned of the latest Fed move while unveiling the 1995 Continental (estimated sticker price: more than $35,000) at a Washington gala. "I'd start to feel that we might not only slow the momentum in auto sales but kill it."

Defenders of the rate hikes make the following case: with unemployment at just 5.8% and factories humming along at nearly 85% of their capacity, the U.S. economy is in a dangerous zone. "These are the classic signs of an overheating economy," says Lyle Gramley, a former Fed governor who is chief economist for the Mortgage Bankers Association. "It's very clear what's happening, and it's something that people who don't look beneath the surface don't acknowledge."

In this view, the Fed is likely to keep tightening credit until the economy slows from a feisty 3.4% rate of growth in the third quarter to a more sustainable 2.5%. If the Fed can achieve that goal, it would accomplish a rare "soft landing," the jargon for slowing just enough to restrain inflation without sending the economy into a slump.

But critics argue that there is no need for such maneuvering, which risks bringing on a recession, because inflation is already under control. Such economists gained support last week when the government reported that the Consumer Price Index, a key gauge of inflation, had risen in October by a minuscule 0.1%.

In addition, the Fed's critics insist that traditional warning signs of inflation like high rates of factory utilization are no longer reliable. That's because the U.S. economy has become so productive, they argue, that companies can build and sell more of everything, from cars to computers, without having to push up prices. At the same time, U.S. firms have ) constructed so many factories abroad that measurements of how fully they are using their plants at home no longer indicate their true capacity.

All this has led some critics to assert that the Fed has been paying less attention to what is happening in the economy than anticipating the psychological reactions of the bond market. They see a parallel in the way the Clinton Administration decided last year that any push to stimulate the economy would cause bond investors to detect the threat of inflation and lead to higher interest rates.

For a moment last week, the bond market's psyche was easy to read. So eager were traders for higher rates that William Reynolds, director of fixed-income investments for the T. Rowe Price group of mutual funds, dreamed the previous night that the Fed had failed to act. In the nightmare, Reynolds said, "we were running around the office yelling, 'They've got to do something; they've got to do something!' " When news of the rate hike flashed across his screen, Paul Boltz, the chief economist for the funds, exclaimed, "Oh, they took my advice! Oh, this is good!"

But the excitement quickly fizzled."The market basically said, 'That's not it,' " notes David Glen. The market said a lot of people are waiting to see what the next step will be.

Despite the market's cool reception, the latest hike will clearly slow spending at a time when stagnating incomes have forced millions of Americans to use credit cards for everything from dental bills to trips to the supermarket. Consumers owed nearly $4 trillion at the end of the second quarter; that equaled 81% of their disposable income, the highest such ratio on record. Experts estimate that last weeks rate hike could add as much as $20 billion next year to the interest paid on everything from credit cards to mortgages. Interest charges on bank and credit cards alone could jump $5 billion.

Rising interest costs will also slow the expansion of small companies, which generate lots of jobs but because of their size must borrow from banks at more than the prime rate. No sooner had the Fed moved last week than many banks boosted their primes from 7.75% to 8.5%. That was harsh news to Leedom Kettell, who runs a printing company in Syracuse, New York, with 10 employees. Kettell had been shopping for a new $40,000-to-$50,000 printing machine for his growing business."But now, with the higher rates, I'm doing all I can to avoid buying," he says. "Postpone is the key word."

; Home buyers who can still afford to shopthe average rate on 30-year fixed- rate mortgages has already climbed from 6.75% late last year to 9.2%, which helped cut housing starts 5.2% last monthare preparing to scrimp on other spending. Two weeks ago, Denver lawyer Patrick Plank and his wife Betsy took out a 9.5% fixed-rate mortgage with a low down payment that they are using to buy an $85,000 town house. "Any interest rate in single digits still looks good," Plank says. But the cost of the mortgage is forcing him to keep his 1987 Toyota instead of trading it in for the newer model he covets.

Such forbearance has begun to worry car dealers. With the average price of an American auto now at $19,200, up $1,000 from a year ago, higher rates could turn interested shoppers into mere tire kickers. To keep sales moving at the brisk pace of 15.5 million cars and trucks a year, the automakers financing units have absorbed part of the higher loan costs instead of passing them along to customers. While that has worked so far, companies fear that sales could drop off sharply if rates go much higher.

Even as the rising rates hurt borrowers, they have been a boon to many savers. Economists say that for every percentage-point increase in short-term rates, holders of securities ranging from Treasury bills to money-market funds gain nearly $20 billion in annual income. Partly for such reasons, experts predict that the latest rate hikes will have little impact on Christmas sales this year. They note that retailers did a respectable, if unspectacular back- to-school business last summer, which usually augurs a solid Christmas season. Moreover, many consumers fail to recognize that the Fed's moves can increase the interest on their credit cards, so they go right on spending. History shows that it takes at least a year for a change in interest rates to spread through the economy, so the full impact will not be felt until late 1995.

The outlook could be darker by then, particularly if the Fed continues to heed the bond market and pushes rates still higher. According to David Blitzer, chief economist of Standard & Poors Corp., there have been nine U.S. recessions since World War II but only two soft landings. In effect, the odds are 9 to 2 against the Fed in 1995.

Attempts to fine-tune the economy have often misfired. President Jimmy Carter tried to fight double-digit inflation in 1980 by discouraging banks and retailers from making credit-card loans and by appealing to Americans to leave home without their plastic. The tactics worked so well that consumers stopped borrowing and sent the economy into a recession just as Carter sought re- election.

In the wake of the Feds decision last week, bond traders at Smith Barney were consumed by a day of more microeconomic moves as the phones came alive with buy and sell orders. Within minutes of the Fed's announcement, one trader ran up to chief bond manager Carballeira and roared, "I've got $20 million 3s offered at 4." He got the O.K. sign. "Joe, I have a customer for $50 million 5s at 3." "Those are done," said Carbelleira. "Joe, I got a customer for $10 million 3s at 5." "No more," said Carballeira, and then: "Hey, is everyone all right?" The traders were too busy making deals to answer.

CHART: NOT AVAILABLE

CREDIT: WEFA, Federal Reserve

CAPTION: To curb INFLATION, the Federal Reserve has raised its target for the FEDERAL FUNDS RATE which in turn has an impact on other rates, such as those for MORTGAGES and TREASURY BONDS

With reporting by Bernard Baumohl and Jane Van Tassel/New York, Tom Curry/Baltimore, William McWhirter/Detroit, Suneel Ratan/Washington and Richard Woodbury/Denver