The FOMC Is Forecasting Below Potential Economic Growth
This is a postscript to Fed Chairman Bernanke's testimony yesterday to the Senate Committee on Banking. Bernanke stated that the FOMC's "central-tendency" forecast for 2006 real GDP Q4/Q4 was in a range of 3-1/4% to 3-1/2%. Splitting the difference, this works out to be 3.4% rounded. Given real GDP growth of 5.6% in the first quarter, the midpoint of the FOMC's central tendency forecast implies growth of a bout 2-3/4% annualized over the remaining three quarters of 2006. The CBO estimates that potential real GDP growth over the remaining three quarters of 2006 is about 3.2%. So, implicit in the FOMC's 2006 real GDP forecast is below potential growth over the remainder of 2006. Perhaps this is why the FOMC expects inflationary pressures to moderate going forward. What is somewhat mysterious is why the FOMC expects real GDP growth in 2007 to accelerate to 3.1% (midpoint of 2007 central-tendency forecast) from 2-3/4% in the final three quarters of 2006. Perhaps the FOMC expects to start cutting the fed funds rate either late in 2006 or early in 2007 as we expect it to.
Given the recent behavior of the Conference Board's index of Leading Economic Indicators (LEI), the FOMC's below-potential economic growth forecast is entirely reasonable. Although the LEI increased 0.1% in June after having fallen 0.6% in May, the 6-month annualized change in the LEI is minus 0.6% -- the second consecutive month in which the 6-month change has been negative. The chart below shows that 6-month contractions in the LEI generally lead to contractions, or, at least, significant decelerations in the index of Coincident Indicators. Although every recession starting with the one in 1960 has been preceded by a 6-month contraction in the LEI, some contractions have not been followed by an "official" recession. However, as just noted, even if a recession does not occur, a sharp deceleration in the pace of economic activity does occur with a 6-month contraction in the LEI. The economic growth slowdowns of 1967 and 1995 are examples of this. Had it not been for Fed interest rate cuts in 1967 and 1995, official recessions might have occurred. Investors ignore the behavior of the LEI at their own risk.
Conference Board's Coincident vs. Leading Economic Indicators
(6-month annualized percent change)
shaded areas represent periods of recession
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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 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.
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