Greenspan Has Spoken, China Is Revaluing And I'm Reevaluating
Don't fight the Fed. That's true for investors as well as economic forecasters. I think that, in the current environment, a fed funds rate in the range of 3-1/4% to 3-1/2% is sufficient to moderate real economic growth to the FOMC's "central tendency" of 3-1/2% and to cap consumer inflation, as measured by the PCE price index excluding food and energy, also at the Fed's central tendency of 1-3/4% to 2%. But Alan Greenspan doesn't think so, as evidenced by the following excerpt from his testimony to Congress this past week: "In our view, realizing this outcome will require the Federal Reserve to continue to remove monetary accommodation." The market has interpreted this to mean that the FOMC will continue to march the fed funds rate higher, probably to 4% before the end of the year. Like Lola, whatever Alan Greenspan wants, Alan Greenspan gets - at least in terms of the fed funds rate.
But if Greenspan insists on pushing the fed funds rate up to 4% by yearend, he might not get what he wants in terms of real GDP growth this year, and especially not next year. (The FOMC's central-tendency real GDP growth forecast for 2006 is 3-1/4% to 3-1/2%.) Why? Because, as was discussed in our July U.S. Economic and Interest Rate Outlook (http://www.northerntrust.com/library/econ_research/outlook/us/us0705.pdf), I believe that Fed policy currently is already considerably less accommodative than it was a year ago when the FOMC commenced raising the fed funds rate. To push the fed funds rate to 4% by yearend would likely move Fed policy to the restrictive side of neutral, which would manifest itself in below-potential real economic growth in 2006 - perhaps considerably below.
Why do I think monetary policy is less accommodative than does the FOMC? Because I concentrate on the behavior of the real M2 money supply and the spread between the Treasury 10-year security and the fed funds rate as indicators of monetary policy whereas the FOMC relies more on the inflation-adjusted level of the fed funds rate. As I have said repeatedly, the Conference Board also implicitly uses the real M2 money supply and the spread as indicators of monetary policy inasmuch as these two variables are among the 10 components included in the conference Board's index of Leading Economic Indicators (LEI). The inflation-adjusted, or real, fed funds rate is conspicuous by its absence from the LEI components. The Conference Board has no theoretical axe to grind. If the real fed funds rate did a better job of foreshadowing the behavior of economic growth than these other two policy-related variables, I am confident that it would be included among the LEI components. Asha Bangalore discussed the changes in the methodology used to calculate the LEI in her daily economic commentary on July 21 (http://www.northerntrust.com/library/econ_research/daily/us/dd072105.pdf). Chart 1 taken from Asha's commentary. It shows that over the past 45 years that there has been a very good relationship between growth trend changes in the LEI and real GDP. As Asha pointed out in her commentary, the year-over-year percent change in the LEI peaked in the Q1:2004 at 9.0% and has steadily decelerated to 2.2% in Q2:2005. If the FOMC continues to raise the fed funds rate, I forecast that the yield spread will narrow more, possibly inverting by yearend, and real M2 growth will continue to weaken. For the record, Chart 2 shows the behavior of these two policy indicators in recent years up through June. In the event, I also forecast that growth in the LEI will continue to weaken, June's LEI strength notwithstanding.
With regard to the FOMC's implicit disregard for money supply growth, perhaps it ought to actually look at the research produced by its staff. Back in 2003, two Fed Board staff economists wrote an International Finance Discussion Paper entitled "Putting 'M' Back in Monetary Policy" (http://www.federalreserve.gov/pubs/ifdp/2003/761/ifdp761r.pdf). Two interesting quotes from the paper are: (1) "The empirical facts point to the conclusion that money provides information important to identifying monetary policy - information that is not contained in the Federal funds rate" [italics added] and (2) "The evidence appears to contradict the prevalent monetary transmission mechanism in which the real interest is the sole channel by which policy affects real quantities and inflation" [italics added].
Reuters reported that in response to a question from a Congressman on Wednesday about the yield curve, Greenspan replied: "The evidence very clearly indicates that its [the yield curve's] efficacy as a forecasting tool has diminished very dramatically because of economic events." The data in Chart 3, in which the shaded areas represent periods of recession, suggest that the efficacy of an inverted yield curve as a forecasting tool of recessions remained intact through 2001. In the past 45 years, an inverted yield curve, i.e., where the fed funds rate is above the yield on the Treasury 10-yaer security, has given a false recession signal only twice - in 1966 and in 1998. Although a recession did not occur in 1967, a significant slowdown in economic growth did occur. And although a recession did not occur in 1999, the fact that the FOMC cut the fed funds rate by 75 basis points between September 29 and November 17 of 1998 in response to the Long-Term Capital Management blowup might have had something to do with heading off a recession. If the FOMC wants to buck the odds and push the funds rate above the bond yield, so be it. But I would not bet against, at least, a growth recession occurring under those circumstances.
In sum, in light of Greenspan's comments this week, I am in the process of reevaluating my interest rate and economic growth forecasts. I had been forecasting a pause in FOMC rate hikes after August 9. Although I had not made a public 2006 forecast for interest rates, I had been assuming that the FOMC would resume funds rate hikes in the spring of 2006. I no longer believe that. In fact, I think a good argument can be made that the FOMC will be cutting the funds rate sometime in the second half of 2006. I also see a good chance that the Treasury 10-year yield will be trading below 4% on a consistent basis in the first half of 2006, if not sooner. As for real GDP growth in 2006, a "2" handle is beginning to look likely if the FOMC actually does follow through with a 4% funds rate by yearend.