Greenspan Heeds the Call for Restraint : And That Sits Well With Wall St.--as Long as Inflation Stays Submerged

The politicians got what they wanted Tuesday--a restrained Federal Reserve Board, which met and decided to leave interest rates alone.

And for now, that’s fine with Wall Street too: Stocks rallied Tuesday afternoon after the Fed adjourned its policy meeting, sending the Dow Jones industrial average up 74.58 points to 7,303.46--just shy of last Thursday’s record close of 7,333.55.

In the bond market, interest rates tumbled on shorter-term securities, a natural response as the near-term threat of another Fed credit-tightening move dissipated.

But by their own actions, investors may be indicating that the economic slowdown the Fed hopes to see soon, to justify its accommodating stance on rates, isn’t likely to materialize. In fact, by some measures, investors appear to be betting on stronger economic growth, not weaker: The Morgan Stanley index of 30 major “cyclical” stocks--which includes such economy-sensitive industrial names as Alcoa, Goodyear Tire and International Paper--has reached record highs in recent days, and is up 10% since April 21, a bigger gain than many less-cyclical stocks have registered in that period.

In addition, long-term Treasury bond yields are still hovering just under 7%, where they’ve been stuck for the last three weeks. If investors expected a meaningful economic slowdown, they should be far more interested in locking in current bond yields before rates tumbled again.

Moreover, Japan’s stock market has been zooming in recent weeks, reflecting rising hopes that the Japanese economy is finally on the road to sustained recovery. But that could also mean that Japanese interest rates, the world’s lowest, may be poised to rise as well--which could have major ramifications for U.S. rates.

Fed Chairman Alan Greenspan knows all of this, of course. He also knows that it’s tough to figure what markets are saying, in the short run, by their actions.

So with some recent government data at least hinting that the U.S. economy might be slowing--and more important, with no sign of accelerating wage and price inflation--the Fed opted to err on the side of restraint.

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Indeed, inflation has remained incredibly subdued, even after the U.S. economy posted a spectacular annualized real growth rate of 5.6% in the first quarter. Despite that growth, the government’s index of wholesale prices has fallen for four straight months.

With that backdrop, the Fed went into Tuesday’s meeting facing a torrent of criticism from corporate executives and politicians of both parties, who insisted that the central bank’s quarter-point interest rate increase on March 25 was unnecessary, and that a second increase would be unconscionable.

“Let the economy grow,” the Fed’s critics demand. “Inflation isn’t a problem,” they say.

On Wall Street, at least among many investment strategists and economists, the refrain has been quite different. Many analysts continue to believe that it’s only a matter of time before inflation begins to accelerate, given the nation’s tight labor market and relatively high factory-usage rates, which suggest little slack capacity.

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The Fed, its supporters say, should take out “insurance” at a time like this: Tighten credit a few notches, making money a little harder to come by, just to ensure that the economy doesn’t overheat and spark an inflationary spiral.

“I expected them to finish what they started,” said economist Lou Crandall at advisory firm R.H. Wrightson & Associates in New York, admitting his surprise that the Fed didn’t follow through on March’s rate increase with another quarter-point rise Tuesday.

“For a relatively minor policy adjustment, they faced heavy political fire,” Crandall said. “Yet the goal here was not to slow the first-quarter boom but to establish conditions to keep the economy on an even trajectory.”

But James Glassman, economist at Chase Securities in New York, believes that the Fed can be comfortable trusting that it still hasn’t fallen “behind the curve,” so to speak: If the economy begins to heat up in June and inflationary pressures appear to build, Greenspan can move to raise rates in early July at the central bank’s next policy meeting.

Glassman’s view is that Greenspan and the other Fed board members could justify holding rates steady for now, because, “like everybody else, they’ve got to be pretty amazed that the economy is so non-inflationary at this level of unemployment,” the lowest in 23 years.

What’s more, Greenspan can make the argument that the Fed’s restraint last summer and fall, after the economy boomed in the second quarter, was rewarded: Not only did growth slow in the second half of 1996, but inflation remained under control.

Even Crandall concedes, “I was making the same argument [for higher rates] a year ago, and the Fed was dead right not to move then.”

Yet many analysts say that with each quarter of strong growth, the risks increase that wages and prices could begin to rise at a fast enough pace to spook the Fed and financial markets. Nobody is talking about a return to double-digit inflation, but with the economy so used to inflation in the 3%-or-under range in recent years, even a rise to 4% could make headlines.

“This is still nirvana” in the economy, said Gail Fosler, economist at the Conference Board in New York. “But the pressures are building.”

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With that mentality on Wall Street, many investment pros believe that bond yields can’t decline much from current levels. And unless yields fall, stocks--already at historically high levels relative to earnings, at least in the case of blue-chip issues--aren’t likely to continue to rocket, many experts say.

After Tuesday’s stock rally, “I doubt if we’re going to see a huge follow-through rally on the upside, or a big reversal,” said Eric Miller, investment strategist at Donaldson, Lufkin & Jenrette Securities in San Francisco.

All of which is to say that the markets may slip back into waiting mode: Waiting for the economic data to tell them how strong things really are, and thus what the chances will be that the Fed’s restraint will be long-lived or short-lived.

* HOLDING STEADY

In the face of heavy criticism, Fed opts not to raise rates. A1

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Hot Industrial Stocks

The Morgan Stanley index of 30 major “cyclical” industrial stocks has soared in recent weeks, which some analysts say is a sign that investors see a stronger economy ahead. Weekly closes for the index, except latest:

Tuesday: 443.87

Source: Bloomberg News