TCS Daily


TCS Host Jim Glassman talks with Jeff Rosen

By James K. Glassman - June 5, 2000 12:00 AM

With higher interest rates, is the economy slowing down? Where is inflation headed and what does it mean for tech investors? Will the Fed raise rates again or cut them in the next year? In the search for answers to these questions, TCS Host Jim Glassman recently spoke with one of America's most accurate economic forecasters. Brian Wesbury is Chief Economist at Griffin, Kubik, Stephens & Thompson, Inc., a Chicago-based investment bank specializing in fixed-income securities.

Jim Glassman: So, let me ask you about your recent report, "Ignore the pundits, the economy does respond to the Fed." You have been saying for a long time now that the economy has been slowing down. Are we now finally seeing signs that the economy is slowing down?

Brian Wesbury: Yes, we are. The Fed has been raising interest rates since last June and with the lag of around 12 months, you should expect to see that hit the economy. I think the Fed was wrong in raising interest rates. I don't think we had an inflation problem. But now we are beginning to see the economy slow down pretty sharply. The stock markets showed us this. Housing peaked in the middle of 1999 and the manufacturing sector of our economy, if you look at the purchasing manager's survey peaked around August or September, and so we're finally seeing that slowdown spill into other areas of the economy.

Glassman: Now, does this mean that you do or do not expect the Fed to continue to raise rates?

Wesbury: I do not expect the Fed to continue to raise rates. I think that what they have done is push the real Federal funds rate -- that's the inflation-adjusted federal funds rate -- to the highest rate it has been in over ten years. The last time it was this high was in 1989 just before the 1990 recession. I used the core CPI. In other words, I strip food and energy out in order to get that real rate and so by looking at that real rate, you can actually, I think, predict some things about the economy. And what I predict is we're going to have a sharp deceleration as we move into the second half of this year with growth around 2 ½ percent at an annual rate and that will keep the Fed from raising interest rates any further.

Glassman: Just so everyone knows, we've been running for the last three years at 4 to 4 ½ percent but recently much higher than that.

Wesbury: Absolutely. And the end of last year was what I think was a special circumstance. We had a number of factors that were impacting the economy: number one, Y2K spending was boosting the economic growth. Number two, as the Fed raises interest rates you see a number of people try to jump in and get their projects going before interest rates go any higher. And number three, at the end of the last year the Federal Reserve injected $50 billion worth of liquidity to try and overcome any banking problems associated with Y2K. All of those things boosted growth much higher than it would have been normally. And I think we're seeing some payback for that today. But also, we're now beginning to see the effects of this Fed tightening as well.

Glassman: Now, Brian, 2 to 2 ½ percent, which is what you said the economy is going to decelerate to -- that actually is the average rate of growth of the economy for the last fifty years. And once that was not so bad, but you are a believer in a new economy. So, if the Fed had not been doing this, what level of growth do you think this economy could achieve?

Wesbury: I think this economy could easily grow between 4 and 5 percent per year. And I believe that that could happen for the next ten or 20 years without creating inflation. And the reason that I can say that is that I believe productivity has accelerated dramatically. The data on the manufacturing side of the economy showed us very clearly and it is being driven by technology. And this new technology that we're experiencing today with computers and the Internet, telecommunications, biotechnology, and the list goes on and on, will continue to raise productivity in the future. And as this all happens, this creates more growth without inflation and I think the Fed targets are way too low in terms of what they believe the economy can do without creating inflation and, therefore, I think these rate hikes this year have been a mistake. And it is unfortunate that we are going to push growth down to under 3 percent in an attempt to fight inflation that I don't think exists in the first place.

Glassman: Can you just explain to people why it is that growth by itself does not cause inflation? Just let me step back for one second. A lot of people feel that if the economy is growing too fast, it overheats and you have problems such as businesses not being able to hire people unless they jack up their labor costs, and essentially these higher labor costs get worked into the system, therefore we have inflation. You don't agree with that dynamic, though.

Wesbury: No, I don't. There are really two ways to look at that issue. The first is if the growth is being caused by what we will call demand side phenomenon, and that could be the Fed. If the Fed were printing too much money, injecting it into the economy creating a red-hot economy, then you might get inflation because the Fed is injecting too much money. But if, as I think is happening today, the growth in our economy is being caused by supply side factors -- new technology, new goods and services being created -- that is really anti-inflationary. It's not inflationary and it is very simple and that is, that we are creating more goods and services with fewer inputs. Those goods and services actually soak up the money that is in the system and actually can create lower prices, not higher prices. In my view of the world, supply-side-driven growth or supply-driven growth is the cat's meow. Not only do you get good growth and low unemployment but low inflation too. And that's the world we live in today. We are not living in a world that's demand-driven. We're living in a world that is supply-driven.

Glassman: And you think that technology is one of the major reasons for that, that for example, in plants in the old economy you can get bottlenecks because companies would not have enough plants built to accommodate, let's say, the demands for new cars. But that's not necessarily true in the new economy.

Wesbury: Oh, absolutely not. Microsoft, if they get more demand for software, it costs them cents or nothing if they distribute it over the Internet, but just cents to print the new CD. If they distribute it over the Internet, it virtually costs nothing. There's a great example of this with Stephen King's latest novel that was only published online and that means, in downloadable form. You didn't order and then have it delivered. Every additional book that Simon & Schuster sells over the web of Stephen King's new book costs them virtually nothing to produce. And that's the difference between this economy and the old economy. We're moving into an information-based society where the laws of increasing returns rule and that means high growth with low inflation. And I think the Fed is misreading this economy and assuming that this strong growth they're seeing needs to be tempered, where in reality, that strong growth is being created by supply-side phenomena.

Glassman: Now, is there any evidence that Alan Greenspan understands some of the factors that you're talking about?

Wesbury: Absolutely. And this is what's so puzzling to me is that in his speeches, he clearly understands the increasing returns and the changes in the economy that technology is bringing our way. Yet at the same time, I think that the Fed is stuck using its old models; they still have mathematical models that had been built over the past thirty years that described, at least in their minds, the way the economy works. And these models will not allow them to escape into this new era, so to speak. I don't know if that's the right language to use. But they keep them frozen in time and are not allowing the Fed's policies to change as we see the laws of increasing returns take over our economy.

Glassman: Now to go back to the effects of what the Fed has done, you believe that the deceleration of the economy is basically already baked in the cake. We're not talking about something that is going to happen as a result of further rate increases. We already have some pretty stiff rate increases already in existence. Correct?

Wesbury: Exactly. And that's an interesting thing, Jim, because the rate hike on May 16th of this year was 50 basis points. The data is showing that a slowdown in the economy began in April of this year when retail sales fell, durable goods orders fell, purchasing manager's surveys slowed down, housing slowed down. There is no possible way that the rate hike in May could have caused the slowdown in April. And so I believe that we're going to see even further slowing in the economy as we move into the second half of this year.

Glassman: And you point out that the real Fed funds rate is now at the highest level since 1989, so if the Fed funds rate is what, 6 ½ percent --

Wesbury: Correct.

Glassman: ... and subtract how much inflation --

Wesbury: Subtract two percent or 2.1 percent core CPI inflation.

Glassman: So we've got a rate, a real rate of about 4 percent. Where is it normally?

Wesbury: Typically, I would like to see that real rate somewhere around 3 percent. And on average, it's probably on average a little bit less than that over, say, the past thirty years or so.

Glassman: Okay. What is this going to mean to technology companies? I mean, are we going to see a serious slowdown in computer sales, in growth in telecommunications and all sorts of areas where companies have made some pretty big investments?

Wesbury: I think we're going to see a slowdown impact on virtually every area of the economy. However, technology because of the potential that it has to increase profits through productivity will continue to grow much faster than the economy as a whole. But one of the things that we've clearly seen over the past year is the stock market behaving in a much more negative fashion that it did through most of the 1990s, and I believe that part of that is that the market has lowered its earning estimates as we go into this next year or so.

However, one of the interesting things that I think will happen is that inflation will begin to fall later this year and early next year, and it will allow the Fed to bring the rates down with it. So I expect that by the end of this year or early next year, we will actually be talking about when the Fed will cut interest rates and as a result of that we're going to see the stock market get right back on track. In fact, we saw a little bit of that last week. As the fear of the Fed diminishes, I think that the stock markets will move right back on track and we will begin to price in much stronger growth as we move into the future.

Glassman: One more question, Brian. Another area where change could be putting a downward pressure on prices, increasing supply, is globalization. Does that factor into the way you see the world?

Wesbury: Absolutely. Technology is creating changes in many, many areas of our economy and the world. Obviously, the first is that it increases productivity and increases the supply of goods and services in our economy; that's very anti-inflationary. Number two, it brings the world closer together. It allows production facilities to be placed anywhere in the world and have virtual real-time communication with those facilities and as a result we're seeing dramatic increases in competition from around the world, but also resource reallocations that move resources to the lowest cost area production. And that's a fabulous development for inflation as we move into the future.

Number three, technology is changing the way our government relates with our economy. As we have seen, both parties, the Democrats and the Republicans, are vying to be the friend of the Internet, so to speak today, keeping taxes away from that industry and trying to do everything they can to help the economy. That's a dramatic development in terms of regulatory inflation that we might see. That also helps inflation as we move into the future. The final thing is that technology keeps economic growth up and as long as economic growth is strong, the Fed thinks inflation is coming back, so they raise rates. That also keeps inflation down.

So there are any number of inflation fighting positive factors out there and that is why I do not think that inflation will be a problem for the next ten or twenty years as we sit here today.

Glassman: Well, thank you, Brian. I just want to add I have a great deal of respect for your prognostications. You have been someone who has consistently said that inflation expectations were overblown and you're being proven right.

Wesbury: Well, thanks, Jim.
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