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REVOLUTIONARY MONETARY POLICY
Prepared by Bank One Corporation
Econ 101 courses around the world teach that central
bankers cannot fine-tune their economies with monetary policy. The tools
of monetary policy are generally considered blunt instruments, incapable
of the necessary precision. Text books argue that monetary policy cannot
alter the long-term growth path of the economy. Instead, it is better used
as a tool to minimize fluctuations around that path. The view regarding
the short-term limits of monetary policy is so strong that Milton Friedman
once argued that we would all be better off if the Federal Open Market
Committee (FOMC)--the policy-setting arm of the Federal Reserve--set the
money supply to grow at a predetermined rate, closed up shop, went home,
and tended their gardens.
The reality of globalization, the accompanying structural change, and
financial market crises, altered that thinking. The Fed's steadying hand
was critical in calming financial markets during and after the crises of
1987, 1997, 1998, and the turmoil that followed the events of September
11.
It is even arguable that the Greenspan Fed played a key role in raising
the long-term trend on productivity and, hence, potential growth in the
1990's. By experimenting with policy--changing its strategy as the economy--demanded
it was able to keep inflation low for much of the decade. The result, as
New York Fed President Bill McDonough commented in a recent speech, forced
senior managers to more efficiently allocate scarce resources and boost
productivity. By 1996, it was clear that the economy could grow at lower
rates of unemployment than anyone thought possible without triggering inflation.
The virtuous cycle of the 1960's was reborn.
The process was not without its risks. The quick easing by the Fed during
the 1998 financial market crisis helped avert a larger credit crunch. The
inability to quickly normalize rates after that crisis, however, may have
contributed to the asset bubble of 1999. Indeed, it is arguable that the
Fed became the default central bank to the world in the fall of 1998, and
as a result, could not retrench its steps as quickly as it should have
for the U.S. economy.
This edition of One View takes a closer look at the Fed's ongoing experiment
with monetary policy, what it suggests about policy shifts going forward,
and the risks that lie therein. It is always easier to ease than tighten,
and the risk is that the Fed will fall behind the curve in the months ahead.
A Dual Mandate
The Fed has a dual mandate. It is charged with maintaining both full
employment and price stability, which, essentially means keeping the economy
as strong as possible without triggering inflation. The duality of the
mandate is not surprising given that the rules for the current FOMC were
established in 1935, during the height of the Great Depression.
This contrasts the more singular focus of other central banks on price
stability, and has allowed the Fed a level of experimentation that we have
not seen elsewhere. The most notable experiment prior to 2001 was the "growth
experiment" of the mid 1990's, when the Fed allowed unemployment to fall
further than previously thought possible, without tightening. Increased
efficiencies in the economy lowered the rate at which unemployment would
trigger inflation, and as a result, gave the Fed leeway to experiment with
low rates until inflation showed signs of re-accelerating.
Risk Management
Readers of this report are familiar with the characteristics of the
Fed's most recent experiment. When the Fed shifted its perspective on risks
from inflation to economic weakness on December 19, 2000, it embarked on
a whole new era in the setting of monetary policy. Instead of managing
the baseline forecast, which suggested that the expansion would slow, but
continue, it began to manage the downside risk of recession. The reasons
were fairly straight-forward:
--The risk of recession was rising, and that seemed an unnecessary risk
to run while inflation was still low.
--On the political front, Greenspan had been blamed for the elder Bush's
recession, and was not about to be blamed for his son's.
The result was the most dramatic easing of credit conditions of the
post-World War II period. The fed funds rate dropped from 6<$E1/2>%
at the start of January to 1% in December. Moreover, many inter-meeting
moves were used to emphasize the Fed's commitment to defend growth, even
if it meant overshooting later in the game. (See Chart 1.)
Chart 1
The Aggressive Easing Of 2001
Note--Inter-meeting dates on 01/03, 04/18, and 09/17.
Positive Results
So far, the new strategy appears to be working. Recent evidence suggests
that the economy was on the mend in the summer of 2001, and would likely
have avoided recession had it not been for the events of September 11.
Even the National Bureau for Economic Research (NBER), the group that officially
dates recessions, admitted that losses prior to September 11 were too small
to justify "recession" status. Moreover, many analysts are now questioning
whether a recession occurred at all.
If the Fed was willing to deliberately overstimulate the economy to
avoid recession, then it should be equally committed to "normalizing" rates
now that the risks of recession have passed. If it doesn't, it risks a
repeat of the 1999 bubble or worse. Moreover, the Fed would be wise to
tighten sooner rather than later given the lags in monetary policy. It
takes anywhere from twelve to eighteen months for the full effects of a
change in policy to work their way through the economy, and the first easing
occurred on January 3, 2001.
Not An Easy Transition
The Fed's recent move to a balanced risk stance at its meeting on March
19, 2002, marked the first step in its transition from hedging the downside
risks of recession to normalizing rates. However, there is a big difference
between a shift in stance and an actual tightening of monetary conditions.
Historically, the Fed has used the "cover" of rising inflation or falling
unemployment to raise rates, neither of which is expected to occur in the
near-term. (See Charts 2 and 3.)
Chart 2
Benign Core Inflation
Core CPI, % change, SAAR*
Seasonally adjusted annual rate.
Chart 3
Rising Unemployment
Unemployment rate, %
Add to that, the political realities of mid-term elections, and the
Fed will feel even more pressure to move slowly. The head of the GOP predicted
that the Fed would have no need to raise rates in 2002.
A Conundrum
So, what is a conscientious Fed to do? It should seize the earliest
opportunity to start raising rates. The May 7 meeting is only eleven days
after the release of first quarter real GDP data, which are expected to
be extremely strong perhaps even in excess of 5%. That, coupled with the
bond market's reaction, which has already priced some fairly aggressive
monetary tightening into the market, should give the Fed the opportunity
it needs to make its first move. Financial markets are already pricing
in 200 basis points of tightening over the next year.
An additional move is likely at the Fed's regularly scheduled meeting
in late June. After that, however, moves will have to be more strategic.
A first half of the year average of stronger-than-potential growth should
give the Fed the cover it needs to complete its mission. (See Chart 4.)
Chart 4
A Re-accelerating Growth
Real GDP, SAAR*
*--Seasonally adjusted annual rate.
The preliminary read on the second quarter is not released until
late July, which means a more aggressive move is likely at the Fed's regularly
scheduled August meeting. That leaves October and December to complete
the retrenchment.
The fed funds rate is forecast to end the year at 4%, a rate considered
neutral given our outlook for strong level growth and robust productivity
gains.
Risks Of Overshooting
The primary risk is that the Fed falls short in reaching its goals of
normalizing this year, and liquidity in the economy continues to grow at
a rapid rate.
Indeed, the risk is high that the Fed is already too late. The forecast
for tightening is still a forecast, not a reality, and the lags in monetary
policy are substantial. We are not likely to "feel" the full effects of
tightening until well into next year. In the interim, the easing that characterized
all of last year will be influencing economic and financial market gains.
Moreover, timing shifts in monetary policy are extremely tricky. The
Middle East and War on Terrorism present the threat of unforeseeable events
that could delay Fed actions in 2002.
The Bottom Line
By pursuing a strategy of risk management over a baseline management
of monetary policy, the Fed has embarked on a policy of fine-tuning the
economy, a concept most economists think is dangerous.
So far, the payoffs to such a policy appear to have outweighed the risks.
There is little doubt that the consequences of the "tech wreck" and the
events of September 11 would have been significantly worse if the Fed had
not been so proactive. However, we have yet to see the full effects of
such a strategy on financial markets and the broader economy.
Look for the volatility that we have seen in short-term rates to continue
as markets try to digest the reality of a Fed that tightens without the
cover of inflation or falling unemployment. Equity values are also likely
to rise as the lagged effects of earlier easing play out; hence, our bullishness
on the outlook for equity markets in 2002.
Greenspan will leave a remarkable legacy. His confidence and humility
to change policy to accommodate ongoing shifts in both the national and
global economic environment are unprecedented in the history of the Fed.
At the same time, he has increased the transparency of Fed decisions and
tried to more accurately communicate the intent of Fed actions to financial
market participants.
However, the process is not without its flaws. As recently as January,
the Chairman found himself correcting a statement that he made in San Francisco
because it was so badly misinterpreted by Wall Street participants. The
process of normalizing rates will no doubt be a difficult one, fraught
with risks of misinterpretation and overshooting. The job won't get any
easier as we move closer to mid-term elections. It is not an enviable time
to be on the FOMC. They will need all the luck and courage they can muster
to avoid a mistake down the road.
National Roundup
Real GDP was revised up in the fourth quarter to 1.7%, putting an end
to any voices of concern that the recession (if we had one at all) was
deep. Preliminary data for the first quarter are significantly better.
Weaker payroll gains are being offset by robust productivity growth. Consumer
spending remains in the black, aided by tax cuts, a mild winter, and persistently
low energy costs. Equipment spending is coming back (with a vengeance)
after a year of declines. Government spending remains strong and the drag
from inventories has abated. The only persistent weak spot is trade, which
suffered from a stronger gain at home than abroad. Real GDP is forecast
to rise 4.9% in the first quarter, with risks that it could be stronger.
Spectacular first quarter gains will borrow slightly from the second
quarter. The change in inventories, in particular, is not expected to be
as great in the second quarter as it was in the first. The trade situation
is also expected to remain a drag on growth. On a more positive note, consumer
spending should regain some of its momentum, with payrolls continuing their
slow crawl back; equipment spending is expected to continue to rise, fueled
by improving profits and the ongoing push to gain efficiencies by large
firms; and government spending is expected to remain robust. The War on
Terrorism is heating up, commitments made after September 11 have yet to
be spent, and legislators are expected to accelerate pork barrel spending
ahead of mid-term elections in November. On net, real GDP is forecast to
rise 3.2% in the second quarter.
The result is an economy that looks more like the mid-1990's than it
has during the 2000's. Growth will be more balanced between consumer and
business investment, profits and investment will trigger a self-feeding
cycle of profits, investment, and productivity gains, and for a period,
the economy will resume a more virtuous cycle, with robust gains, and low
inflation.
A Regional Roundup
This section takes a closer look at the outlook by key Bank One regions.
The difference in performance between regions hurt by a lack of tourism
and those benefitting from a mild winter is expected to narrow in the year
ahead.
Great Lakes--Vehicle production is on the rise, and being revised up
every month. This will feed into income gains, especially given that much
of the current increase is being achieved with overtime. Separately, the
heavy truck industry is showing some signs of life. The rebound in manufacturing
may not come soon enough to prevent an increase in manufacturing bankruptcies.
Many suppliers, in particular, have been holding on by a thread, and will
not make it through the recovery without going bankrupt. Indeed, manufacturing
bankruptcies tend to lag the turn in manufacturing by about nine months.
Southeast--A return of harsh weather to the Midwest and Northeast in
March helped push more snowbirds south at the end of the first quarter.
Those gains, however, will not be enough to offset a hard winter for tourism
in Florida. Separately, vehicle production continues to push capacity limits
in Kentucky, and a rebuilding of inventories should eventually feed into
the packaging industry. Trucking has already begun to pick up with the
increase in manufacturing activity.
Oil Patch--Texas suffered especially hard losses in the fourth quarter.
Everything from weak trade to the "tech wreck" to the Enron debacle to
low oil prices took their toll on the state. Things, however, are beginning
to look up. Mexico's economy is picking up, which will help border cities,
while increases in vehicle production should benefit plants on both sides
of the border. Louisiana and Oklahoma will lag Texas, but should improve
from recent lows. Tourism is on the mend, which is a plus for New Orleans,
while imports are accelerating, and Louisiana is a major import hub.
Mountain--Tourism has begun to pick up in both Arizona and Colorado
in recent weeks in response to poorer weather conditions in the Midwest
and Northeast. An earlier-than usual Easter holiday also helped, triggering
sooner-than-usual spring travel. Those gains will not be enough, however,
to make up for what has already been a fairly dismal tourism season. Separately,
Utah did much worse than hoped during the Olympics, and as a result is
now faced with some very deep budget cuts, which will place a drag on growth
in the state. On the brighter side, the tech sector appears to be bottoming
and defense spending is picking up. This will eventually feed into Colorado,
which needs it.
April 17, 2002
Diane C. Swonk
Bank One Corporation
One First National Plaza, Chicago, Illinois
312-732-3779
www.bankone.com
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