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Revolutionary Monetary Policy

April 17, 2002

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


*--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.

Nevada accounts for 75% of U.S. gold production.
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