WASHINGTON, June 29 (UPI) -- The Federal Reserve Open Market Committee meets Wednesday and Thursday and will raise the target Federal Funds rate another quarter point to 3.25 percent.
This action will have little effect on long-term interest rates, such as 10-year Treasuries and mortgages, and few consequences for the economic outlook.
The economy's vital signs remain good. Inflation is moderating, employment is growing, and the economy will likely post growth in the range of 3.5 percent this quarter-higher than economists had predicted in May. During the second half of 2005, the economy may slow from rising oil prices and consumer exhaustion but significant signs of a slow down are not yet at hand.
But is the economy fundamentally sound?
On the one hand, the corporate sector looks good. Investment is expanding and profits are better than the stock market's tepid performance indicates. On the other hand, consumer spending is running on steroids -- debt keeps climbing, housing prices are in a bubble and the shopping fest at Wal-Mart are pushing the trade deficit and foreign borrowing close to 6 percent of gross domestic product.
With consumers spending and new home construction accounting for more than three-fourths of GDP, how does the Fed cool down consumers' enthusiasm without bring about a collapse?
A year ago, the Fed began raising the Federal Funds rate, pushing it from 1.0 percent to 1.25 percent, and the Fed has been ratcheting up short rates every six weeks since then. In that time, the rate on 10-year Treasuries, which does far more to determine the home equity and mortgage rates, has fallen from 4.62 to 3.97 percent.
This greatly frustrates efforts to cool consumer spending. Mortgage rates and terms are better than a year ago-zero interest, zero down and zero closing costs have realtors and their clients in hysteria. Like unwitting investors during the high-tech bubble, home buyers are bidding as if God has chiseled in marble, "Prices shall never fall again."
Similarly, low long-term rates keep home equity loans, rates from car dealers and credit card terms reasonable. Consumers at the mall and new car buyers are postponing the inevitable reckoning that will come when they can no longer service more debt from rising equities.
Quite simply, if Fed Chairman Alan Greenspan cannot control long rates, he can little do to dampen the housing bubble, reduce the pace of the consumer spending or effectively manage the economy, short of taking draconian regulatory actions.
What's the problem?
For one thing, higher oil prices have dampened prospects for global growth, and that tends to pull down long term rates.
Even more important, though, the U.S. trade deficit is nearing 6 percent of GDP, and foreign central banks are loaning Americans the money to finance it. Last year China's central bank, alone, spent 12 percent of China's GDP on foreign, mostly U.S., securities. Most of the $355 billion in U.S. paper acquired by central banks in 2004 went into securities -- Treasuries, other government agency paper and bank deposits. All that demand for U.S. debt drives U.S. long-term interest rates down.
Essentially, to keep their currencies from rising in value and rebalancing trade, China and other Asian governments are buying dollars, giving Americans their currencies to spend on imports, and recycling those dollars into U.S. Treasuries and other securities.
Greenspan can't push up long rates any more readily than GM can raise prices for much the same reason: foreign competition. In the Fed's case, it's China's central bank bidding down the market interest rate on U.S. Treasuries and other securities.
Were China to revalue its currency and other Asian governments to follow suit, their intervention in currency markets and U.S. credit markets would become too small to matter. Then Greenspan could reassert control over U.S. interest rates and monetary policy.
As long as China maintains the yuan peg, and massively intervenes in currency and credit markets, the Fed has about as much control over long-term rates as GM has over the price of Chevy Blazers.
Maybe Greenspan and GM's Rick Wagoner could spend The Fourth of July comparing notes and discussing the consequences of globalization.
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(Peter Morici is Professor of Economics at the Robert H. Smith School of Business, University of Maryland.
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(United Press International's "Outside View" commentaries are written by outside contributors who specialize in a variety of important issues. The views expressed do not necessarily reflect those of United Press International. In the interests of creating an open forum, original submissions are invited.)
