Wall Street's Ghostbusters

A specter is haunting Wall Street--the specter of runaway interest rates. Yields on bellwether U.S. 30-year Treasury bonds in early June jumped to just over 6%, the highest close in more than a year, as nervous traders bid prices lower. They are taking no chances that a flare-up of inflation will squeeze the real return to buyers.

But in the gloom-and-doom scenario, the Federal Reserve Board will not be satisfied with such modest rate hikes. In order to nip in the bud any renewal of inflation, the Fed will begin an aggressive tightening of credit and deliberately push interest rates much higher still. That will cause a chain reaction. It will knock stock and bond prices much lower, make consumer buying and business investment more difficult to finance, and maybe put a stop to what is about to become the longest economic expansion in U.S. history.

Relax. That won't happen. This specter is no more real than the many others that stock and bond traders torture themselves with every now and then, especially when times are good. In fact, inflation is likely to revive only slightly, if at all. The Fed may not tighten at all, and if it does, it will most likely be with a small, one-shot move that's already been discounted. Interest rates a year from now may well be lower than at present.

That is the conclusion of TIME's Board of Economists, which met recently in Manhattan to assess prospects for the U.S. economy and stock market. And that opinion comes from Wall Street itself; on this occasion the board was composed of influential investment advisers, chosen to offer a different perspective from academic and corporate economists. The panelists disagreed considerably on the likely course of the stock market and the broader economy next year and after. But on the subjects of inflation and interest rates they chorused in unison: not to worry.

A sharp further rise in interest rates would be "a dagger in the heart" of the U.S. stock market, says Vincent Farrell, chief investment officer of Spears, Benzak, Salomon & Farrell, an investment firm. But he believes the dagger is well sheathed: "Interest rates have probably about run their course." Abby Joseph Cohen, who chairs the investment policy committee at Goldman Sachs, is more emphatic. Says she: "I think yields on long-term bonds cannot move much higher and stay there on a sustained basis."

Joseph Battipaglia, chairman of investment policy at Gruntal & Co., a major brokerage company, predicts an actual decline in the rate of the 30-year Treasury bond to around 5.75% by year's end and possibly to 5.5% sometime in 2000. Barton Biggs, chairman of Morgan Stanley Dean Witter Investment Management, is generally the most pessimistic of the board members, but on this subject he goes Battipaglia one better. His prediction: "A year from now [the 30-year Treasury rate] will be in the area of 5%."

But hasn't the Fed officially warned that it has a "bias" toward making money and credit tighter? Yes, allows the board, but the Fed may already have accomplished as much tightening as necessary--or maybe more--by subtle measures. True, it may kick up the "Fed funds" (very short-term) interest rate it controls by a modest quarter percentage point at its rate-setting meeting at the end of June--"just to prove it can do it, for practice," in Farrell's words. But such a move has been so widely expected, and discounted, that board members think it won't ruffle the markets much.

The only reason interest rates are even as high as they are now, says Charles Clough, chief investment strategist of Merrill Lynch, is "the bond market's proclivity to identify growth with inflation." But that proclivity, in the board's opinion, is simply wrong: there is no inflation threat scary enough to push the Fed into drastic action. Prices did spike abruptly in April, but that, says Clough, was due largely to a speculative rise in industrial commodity prices that "has already lapsed." Though Asian countries are starting to recover from the crisis that knocked demand and commodity prices so far down in 1998, recovery has been too weak, in the view of board members, to sustain the early-spring increases.

Battipaglia adds that "wage increases will be more than offset by productivity gains, despite the remarkably low U.S. unemployment rate--4.2% in May, matching a 29-year low--that might be expected to force pay and prices up faster. Employers will have less trouble than the jobless rate might suggest in finding the workers they need, he says, for three reasons. First, "you have had a tremendous amount of downsizing that freed up a lot of individuals who are now coming back" into the work force. Also, "second wage earners"--primarily wives and husbands--who may not have been counted as unemployed because they were not actively seeking jobs are now being pulled into the job market. Finally, "you have a million legal immigrants [coming] into the U.S. each year." Though it would be too much to hope for a 1999 inflation rate as low as last year's 1.6%, Battipaglia thinks consumer prices will rise only around 2.5% this year and perhaps 2.3% in 2000.