There is no better 'reality check' for policymakers than this type of discussion with people who actually move markets. As Alan Greenspan, the chairman of the US Federal Reserve Board, was delivering an upbeat assessment of economic growth last week, some of Wall Street's biggest money managers were singing a different tune.
They foresee an economic downturn directly related to President Clinton's budget negotiations with Congress, which many decline to acknowledge as a deficit reduction. 'From the numbers I see, I see big tax hikes that will be contractionary for growth and not nearly enough spending cuts. The result will be continued high fiscal deficits for several years out,' said one mutual fund manager.
Meanwhile, Mr Greenspan was delivering surprisingly good economic news - that the US economy grew by a stronger-than-expected 3 per cent in the second quarter and was on track for overall growth of 2.5 per cent this year. Unemployment, now high by US standards at 7 per cent, would decline to 6.75 per cent by December. Mr Greenspan's one big worry was inflation, which he said was stabilising in the 3 to 3.5 per cent range rather than subsiding as one would have expected with unemployment hovering at 7 per cent. He thus dangled the threat of higher interest rates before nervous bond markets, even as he sought to keep up the pressure on Congress to pass a substantive deficit reduction programme of dollars 500bn over five years. 'Should the expectation of deficit reduction be thwarted or scaled back, markets will react appropriately negatively,' Mr Greenspan predicted.
He agreed with portfolio managers that US growth would be restrained for months as a result of high consumer debt and big cuts in military spending. But he disagreed over the nature of the economic foundation being laid in the deficit reduction negotiations. Assuming that the fiscal deficit is actually restrained and that the healthcare crisis is resolved, the US economy should emerge 'healthier than it has been in decades,' according to Mr Greenspan.
The big question, of course, is who is right? The negative attitudes of many in the financial community are not surprising given the very murky indicators of future US growth. On the macroeconomic front, growth has been quite sluggish in relation to traditional post-recession recovery rates of 6 per cent or more. The fact that the Fed is worried about inflation suggests higher short-term interest rates in the very near future.
Sectorally, there are also big trouble spots. The US airline industry, for example, is in such bad shape that a Federal panel recommended special help. It proposed sweeping tax cuts on transportation fuels and passenger tickets, and minimum tax rates for the airlines to assist the ailing industry. Additionally, one need only fly over the rain-soaked Mid-West and glimpse its bulging rivers to realise that the total cost of the flooding will be many billions of dollars.
Deficit reduction is another big unresolved issue. Mr Greenspan believes that it must be substantive. Portfolio managers are unconvinced, because of the lack of bigger spending cuts, most notably in entitlement programmes. The ultimate success or failure of whatever is agreed by Congress may ride on the fate of one man, Dan Rostenkowski, the powerful chairman of the House Ways and Means Committee. As has already been reported in this column, he is critical to the success of President Clinton's present and future economic programme because he is the only House official at present with enough strength to push through the politically unpalatable parts. If he is indicted on embezzlement charges related to the House Post Office scandal - as has been reported in many papers - he will be forced to step down until the charges against him are settled.
A final unknown is the role that the Fed itself will play in influencing future economic growth. Mr Greenspan acknowledged last week that the traditional money-supply tools that the Fed has used to engineer growth are no longer reliable. It is unclear now how the Fed will set targets for real interest rates, its new guide post in determining economic growth.
Since the late 1970s, the Fed has based its most important decisions on specific targets for growth in the money supply, defined as money in circulation plus savings and checking accounts. Now, it is relying on targets for real interest rates, which are determined by subtracting the inflation rate from nominal interest rates that have inflation built in. Thus, a 5 per cent interest rate actually translates into a 2 per cent real interest rate, if inflation is at 3 per cent. In seeking to set real interest rates at levels that produce steady growth with low inflation, the Fed is in effect guiding the economy by the stars rather than by the scientific methods it has used in the past. How well this will work is an open question. We therefore end the debate with no clear answer as to who is right, the portfolio managers or Mr Greenspan.