GETTING INSIDE GREENSPAN'S HEAD
Diane C. Swonk
Bank One Corporation
A Common Mistake
Most financial market participants forecast monetary policy moves as if they themselves are making the decision on where rates should move. The problem is that only the members of the FOMC have an actual say in where interest rates will go. Therefore, the only way to reasonably forecast the course of monetary policy at any point in time is to have both a view of the economy and a good understanding of how policymakers are likely to react to that view.
This is especially true of turning points, when not only the direction, but the pace at which rates move can make a tremendous difference in the way financial markets and the economy reacts to those shifts.
Financial markets have backed off a bit in recent weeks in response to renewed terrorist threats. The Fed remains more intent on gradualism and avoiding the mistakes of 1994, however, than most financial market participants appear to believe. Moreover, Greenspan is planning his legacy, and has no intention of leaving with the economy in a shambles because of too aggressive tightening today. The rest of this report takes a closer look at the medium-term agenda of Chairman Greenspan and the Federal Reserve.
A Policy-Neutral Rate
Now that the expansion is well-established, the Fed has shifted its focus from averting further weakness to normalizing rates. The greatest challenge in that process is determining the policy-neutral Fed Funds target--the rate at which policy is neither contractionary nor stimulative. This rate will determine both the pace and degree to which the Fed tightens over the next eighteen months.
Most analysts are making sense of this issue along the following lines:
Over the past several decades, the inflation-adjusted Fed Funds rate has averaged 2.%. Therefore, with core inflation in a 1% to 2% range and large, chronic Federal budget deficits, the policy-neutral rate (and target for 2005) should be at least 4%. Moreover, it could be even higher if core inflation moves above the "acceptable" 2% range over the next eighteen months.
On the surface, the approach seems reasonable. It not only falls in line with historical norms, but it is also highly consistent with the Fed's behavior in 1994, the last time it tightened as the economy was rebounding from a prolonged and somewhat painful recovery. (See Chart 1.)
The 1994 Tightening Debacle
Fed Funds Rate Less Core CPI
Such a large rise in rates, however, represents an enormous jump from today's 46- year low of 1%, and would have substantial financial market and economic consequences. This is where it pays to assess Greenspan's personal goals and listen to the message given by the members of the FOMC, rather than play arm-chair policymaker.
The best bet is that the Chairman will step down once his term as Governor expires in January 2006. There are many reasons for such a bet, the most notable of which is his age. He turns 80 on March 6, 2006, and even if he could serve effectively in his eighties, that could be a dangerous precedent for any Fed Chairman to set.
That means that we need to understand Greenspan's end-game strategy--how he wants to be perceived upon his exit--in order to understand where the Fed will be moving between now and the end of 2005. To understand that, it is necessary to take a deeper look at the Chairman's monetary policymaking process.
Greenspan defined the early years of his stewardship as the most solitary and analytical of Federal Reserve chairmen. He loves poring over data, looking for short-term indicators and longer-term trends. While the rest of us were watching the drama of the first Gulf War on CNN, the Chairman was spending his hours watching how those events were affecting global financial markets on his computer screens.
His take on long-term trends is most consequential to figure out how he will act over the next several quarters.
Learns And Integrates
Greenspan is a learner and willing to admit past mistakes. He would particularly like to avoid a repeat of the markets' inability to absorb rate hikes in 1994, and near-train-wreck of the economy in 1995.
In that context, Greenspan has worked diligently to more fully integrate anecdotal as well as hard economic data into the process of policymaking. The GDP data missed both the 1990-91 and 2001 recessions as they were happening, despite anecdotal reports suggesting that businesses were having a much harder time than suggested by the "official" data.
Those reports were part of what prompted the Fed's historic pre-emptive move to ease ahead of the recession, and blunt the blow of bursting financial market bubbles on the economy, on January 3, 2001.
Believes In Structural Change
In recent years, Greenspan has embraced two structural (long-term) shifts that have occurred in the U.S. economy.
The first, and probably most important, is the changes that have resulted from widespread deregulation. Changes in the financial service industry have been particularly large, generating fairly substantial and uncounted gains in efficiency for the U.S. economy. This includes everything from the almost compulsive focus on costs by large corporations to increased financial market efficiencies associated with greater transparency and the globalization of financial markets.
The second is the continuing positive effects of technological change on productivity growth. Indeed, his formal comments on technological change suggest that we still have a long way to go before realizing the full effects that communication and information technology will have on productivity growth.
Buying into those structural shifts allows Greenspan and the Fed to expect persistently strong gains in productivity growth.
These translate into restrained inflation, robust profit gains, and the opportunity to push the jobless rate lower than the old rules suggest.
Calibrates Policy Moves
The idea is that the Fed can calibrate monetary policy on more of a real-time basis, and has more latitude to react to inflation, than it did in the past. The last time we saw the Fed do this was in the mid 1990's when, with the encouragement of then-Vice Chair Alice Rivlin, the Fed embraced its now famous "growth experiment"--allowing the Fed Funds rate to remain low until we actually saw inflation accelerate.
It also allows Greenspan to reject the consensus policy-neutral real rate of 2.% in favor of a significantly lower and more flexible real (and nominal) target rate.
In addition, the Fed favors the PCE deflator when calibrating the real fed funds rate. This gauge tends to run lower than the core CPI and brings down the policy-neutral Fed funds rate.
Believes In A Lower Target Rate
On net, the Fed's nominal policy-neutral target rate today could be in the 3% to 3½ % range, more than a percentage point below the market's take on the policy-neutral rate. (See Chart 2.)
Weighing A Lower Target Rate
Fed Funds Target
Add to that, the inertial characteristics of inflation, and the recent breakdown of the relationship between wage and price gains, and it is a good bet that Greenspan will win his bet on inflation. Price increases will rise from recent lows, but will remain relatively well-contained in the near-term. (See "Deflation, Disinflation, And Inflation: What's Happening To Prices?" One View, May 11, 2004.)
The spillover of commodity-based inflation and the extent to which wages react to those types of shifts, in particular, have become increasingly muted in recent years. By almost all measures, inflation and wages are running significantly below the levels we should be seeing if the historical relationships were still operating.
It is a very good bet that the structural changes witnessed in the 1990's will continue to deliver stronger growth at lower rates of inflation and unemployment than anyone once thought possible. The result:
- Productivity growth will slow from the phenomenal pace seen since the start of the recovery (it already has), but remain well ahead of historical norms;
- Core inflation and wages will remain more contained than we saw in the past through 2005;
- Profits will remain robust, fueled by persistently strong productivity growth and continued robust gains in top-line revenue growth;
- Equity prices will rally and reach new highs before the current tightening cycle is over; and,
- The dollar should, at least temporarily, strengthen relative to the Euro.
The Fed will raise rates gradually to a lower target rate than many in the market currently expect by the end of 2005. Greenspan will get his wish for an orderly transition, at least while he is still in office. He will leave the Fed on a high note, with his legacy as the most powerful and effective Fed Chairman in history intact.
A delayed and more reactive policy stance today may not be as kind to Greenspan's successor. This is especially true given the backdrop of chronically high Federal budget and trade deficits, what will eventually be a fairly sharp depreciation in the value of the dollar, stronger growth abroad, and the potential for instability in China.
Indeed, uncertainty over how foreign growth affects us is one of the key monetary policy challenges over the long term.
Look for inflation to pick up more rapidly, and the Fed to act more aggressively, once we get beyond 2005. The real Fed Funds target, in particular, could rise instead of fall from the Fed's current estimate, and when that happens, the Fed will have to act accordingly.
The Moral Of The Story?
Enjoy the next eighteen to twenty-four months, as we might look back on them as the best of the 2000's expansion.
A Self-Feeding Recovery
Real GDP was revised up slightly for the first quarter from an initial report of 4.2% to 4.4%. Almost all of the gains were in inventories, suggesting that executives are finally feeling confident enough to hold inventories again. Consumer spending was also revised up modestly. Equipment spending, federal spending, and trade were revised down.
Prospects for the second quarter are about the same, but the composition of growth is shifting even more toward the business sector. Consumers continue to hold their own, despite higher prices at the gas pump (a jump in vehicle incentives to $5,000 per vehicle by GM helped), while business investment is accelerating. Inventories continued to rebuild in April, while preliminary data on May suggest that the heavy manufacturing sector is starting to share in some of the gains of information equipment. Heavy truck sales are doing particularly well. Federal spending also remains strong, buoyed by increased spending in Iraq. The only weak spots are state and local government spending and international trade, which remain drags on overall growth. On net, real GDP is expected to rise 4.5% in the second quarter.
Growth is expected to remain robust in the second half, led by gains in investment and inventories. Consumer spending could also get a lift from a rebound in employment and easy credit conditions. (Higher interest rates are expected to push consumers back into more traditional forms of credit instead of refinancing, but not slow credit demand.) Federal spending will remain strong, aided by last year's budget and additional funding for Iraq. The laggards will remain state and local government spending and trade. Real GDP growth is forecast to approach 5% by year-end.
The Fed Gradually Retrenches
The FOMC is expected to begin a gradual process of raising the Fed Funds rate to reflect stronger growth in the economy, starting June 30.
June 13, 2004
Diane C. Swonk
Bank One Corporation
P.O. Box 520526
Independence MO 64052-0526
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