Bernanke and Co. - Put Your High Beams On!

By: Paul Kasriel | Sun, Feb 19, 2006
Print Email

"[T]he risk exists that, with aggregate demand exhibiting considerable momentum, output could overshoot its sustainable path, leading ultimately--in the absence of countervailing monetary policy action--to further upward pressure on inflation." Testimony of Chairman Ben S. Bernanke Semiannual Monetary Policy Report to the Congress before the Committee on Financial Services, U.S. House of Representatives February 15, 2006.

"[I]n coming quarters the FOMC will have to make ongoing, provisional judgments about the risks to both inflation and growth, and monetary policy actions will be increasingly dependent on incoming data." Testimony of Chairman Ben S. Bernanke Semiannual Monetary Policy Report to the Congress before the Committee on Financial Services, U.S. House of Representatives February 15, 2006.

"But when pressed about what it would take for the Fed to stop raising interest rates, Poole said: 'We would have to see a string of new data observations that (are) coming in on the low side of expectations and we regarded as indicating that the economy (was) really slowing down and inflation pressure coming off.'" Reuters reporter Alister Bull covering speech and Q&A of St. Louis Fed President William Poole on February 16, 2005 in Little Rock, Arkansas.

These quotes from Fed officials suggest that the Fed puts its policy decisions on one set of monthly/quarterly economic data at a time. It's kind of like driving down a dark road at night with your low-beam headlights on. Although you can see that the road is straight a short distance ahead, you cannot see the curve just beyond unless you put on your high beams.

Yes, the January cycle of economic data has been strong. But everyone knows that one of the warmest Januarys on record contributed significantly to the apparent economic strength. And, barring a complete collapse in February and March, first-quarter real GDP growth will be considerably above 3-1/2% -- my perception of potential real GDP growth. But even if firstquarter real GDP growth comes in at 5% vs. the previous quarter, on a year-over-year basis, it would be 3.4%, which would represent a general declining trend in economic growth. And what about policy lags? If the FOMC raises the fed funds rate to 5.00% by May 10, which is what is priced into the fed funds futures contracts and which is what St. Louis Fed President Poole said he was "comfortable" with, that would represent a cumulative 125 basis points of funds rate increases since the beginning of November. Is the FOMC firing blanks?

Let's take a look at Chart 1 below. Notice two things. Firstly, the Fed's preferred measure of consumer prices, the core Personal Consumption Expenditure chain price index, tends to decelerate in growth after or coincident to the deceleration in growth of real GDP. In other words, the rate of consumer inflation tends to be a lagging indicator of the business cycle. I guess this is why the folks at the Conference Board decided to put the CPI for services in their index of Lagging Economic Indicators. Secondly, train your eyes on the part of the chart after the 2001 recession. Notice that real GDP growth already has started to trend lower. On a yearover- year basis, it peaked in 2004:Q1 at 4.7% and had moderated to 3.1% in 2005:Q4. As I mentioned above, even if the quarter-to-quarter annualized growth in real GDP kicks up to 5% in 2006:Q1, it still would be only 3.4% year-over-year. Notice also that the trend in core inflation also has started to moderate – peaking at 2.2% in 2004:Q4 and slowing to 1.9% by 2005:Q4. With energy prices softening, unit labor cost growth trending lower and aggregate demand moderating, what will be the catalyst for an upward trend reversal in core consumer inflation?

Chart 1

If I flip on my "high beams," what do I see? My "high-beam" proprietary real GDP growth forecasting model, the results of which are shown in Chart 2, suggests that the real GDP growth road will continue to head southeast based on what the FOMC already has done. If the FOMC raises the funds rate another 50 basis points to 5.00%, then real GDP road ahead will likely turn sharply in a more southerly direction. This forecasting model is based on lagged values of real monetary growth, the shape of the yield curve and real GDP growth. The purpose of the model is not to give "point" estimates of future real GDP growth, but rather to identify cyclical turning points. A glance at Chart 2 shows that the cyclical turning points of forecasted real GDP growth match up well with those of actual real GDP growth. Yes, the model's real GDP growth forecast has been above actual real GDP growth in recent years. But it has been right on with regard to turning points. The model is now forecasting that year-overyear real GDP growth in the 2006:Q2 will be 75 basis points below model's forecast for 2005:Q4. If the model's directional forecasting accuracy holds, it implies that year-over-year real GDP growth in 2006:Q2 will be below 3%, perhaps below 2-1/2%.

Chart 2
Year-over-Year Real GDP Growth: Actual vs. Forecast*

* Forecast based on a proprietary model incorporating lagged values
of real monetary growth, yield-curve shape and real GDP growth.

If Bernanke does not quickly turn on their high beams, be alert for an economic "accident" in the latter part of 2006 and for sharply lower short-term interest rates, too.


Paul Kasriel

Author: Paul Kasriel

Paul L. Kasriel
Director of Economic Research
The Northern Trust Company
Economic Research Department
Positive Economic Commentary
"The economics of what is, rather than what you might like it to be."
50 South LaSalle Street, Chicago, Illinois 60675

Paul Kasriel

Paul joined the economic research unit of The Northern Trust Company in 1986 as Vice President and Economist, being named Senior Vice President and Director of Economic Research in 2000. His economic and interest rate forecasts are used both internally and by clients. The accuracy of the Economic Research Department's forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005. The accuracy of Paul's 2008 economic forecast was ranked in the top five of The Wall Street Journal survey panel of economists. In January 2009, The Wall Street Journal and Forbes cited Paul as one of the few who identified early on the formation of the housing bubble and foresaw the economic and financial market havoc that would ensue after the bubble inevitably burst. Through written commentaries containing his straightforward and often nonconsensus analysis of economic and financial market issues, Paul has developed a loyal following in the financial community. The Northern's economic website was listed as one of the top ten most interesting by The Wall Street Journal. Paul is the co-author of a book entitled Seven Indicators That Move Markets.

Paul began his career as a research economist at the Federal Reserve Bank of Chicago. He has taught courses in finance at the DePaul University Kellstadt Graduate School of Business and at the Northwestern University Kellogg Graduate School of Management. Paul serves on the Economic Advisory Committee of the American Bankers Association.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.

Copyright © 2005-2012 The Northern Trust Company

All Images, XHTML Renderings, and Source Code Copyright ©