May 4, 2006
IS A PAUSE PRUDENT AT THIS JUNCTURE?
There's a growing chorus of predictions that the economy's due to slow later this year. But recent economic reports don't yet jibe with that view. Could the forecasters be wrong? Or just early?
Nonetheless, the Federal Reserve expects the economy will cool, if only slightly. Thus, Fed Chairman Ben Bernanke's announcement last week that the central bank is considering a pause in the current round of interest-rate hikes.
The Fed wants to avoid a recession. But does pausing with monetary tightening come at the price of letting inflation gain a stronger foothold in the economy?
For some thoughts on that and related questions, we called Paul Kasriel, director of economic research at Northern Trust. In a telephone conversation yesterday, Kasriel expounded on why he too thinks the economy will moderate.
WHAT'S YOUR TAKE ON FED POLICY THESE DAYS?
The Fed's following a restrictive monetary policy. Not necessarily a recessionary restrictive monetary policy. But I think the Fed has already put in place a monetary restriction so that we'll see a lower trend in economic growth. The year-over-year growth in the first quarter was 3.5%, and I think we'll trend lower than that as we go through the year.
WHAT EVIDENCE DO YOU SEE IN SUPPORT OF YOUR OUTLOOK?
There's a lot of evidence in the leading indicators.
I guess I'm one of the last people to still pay attention to the money supply, and we've seen a significant slowdown in the price-adjusted or real M2 money supply.
And although we've seen some widening in the spread between the 10-year Treasury and the Fed funds rate, that spread on a longer-term basis has come down quite dramatically.
Meanwhile, housing has been a leading sector of the economy as a whole. If you look at things on a year-over-year basis, we've seen a definite slowdown in housing activity. Both new and existing home sales have slowed. And [house] prices are softening.
Then there are automobile sales, although I haven't tested them as a leading indicator. But we've seen three consecutive months of flat sales. That is, February, March and April were all around 16.5 million units [for car sales]. That's another indicator of slowdown in the economy.
GOING BACK TO YOUR POINT ABOUT THE YIELD CURVE, DOES THE FACT THAT IT'S BECOME A BIT STEEPER LATELY CONTRADICT YOUR OUTLOOK FOR SLOWER GROWTH?
Historically, a steeper yield curve has been an indication of future stronger economic activity. What it suggests is that the equilibrium structure of interest rates is perhaps moving a little bit higher, and the Fed to some degree is preventing that movement by holding short rates below a level where they would otherwise want to be. But, when the Fed started raising rates [nearly two years ago], the spread between the 10-year and the Fed funds rate was 370 basis points. Today, the spread is 40 basis points, and next Wednesday [the day of the next FOMC meeting] it's likely to be less than that when the Fed raises Fed funds to 5.0%.
If you look at statistical analysis of the spread and economic growth, 90 basis points tends to be the spread that corresponds with about 3.5% growth in the economy. Well, we're at 40 basis points and likely to go to something less than that next week from now.
THE FED'S TIGHTENING, IN OTHER WORDS
Yes, the [falling spread over time] is an indicator of Fed tightening.
By the way, all indicators of Fed tightening are out of fashion right now, except for the so-called real Fed funds right, which happens to be the worst indicator of Fed policy. Nevertheless, it's the one that's in favor right now.
WHAT'S THE REAL FED FUNDS RATE SAYING NOW?
Actually, it's also saying that policy's getting more restrictive.
WHAT DO YOU MAKE OF THE VARIOUS REPORTS OF LATE SUGGESTING THAT ECONOMIC GROWTH REMAINS STRONG?
Just because you have a strong report one month doesn't tell you what's coming in the next month. If real GDP growth were a great leading indicator, I guess it would be in the index of leading economic indicators. But it's not. Things can be very strong one quarter, and turn down the next.
THE JUMP IN GROWTH IN THIS YEAR'S FIRST-QUARTER GDP REPORT RELATIVE TO THE SLUGGISH FOURTH QUARTER CERTAINLY SUPPORTS YOUR POINT.
Well, it does. In the first quarter of 1990, too, there was very strong growth, and then we went into a recession. But when the numbers are strong, and your model is saying it's going to get weaker, it's scary.
IS IT HARD TO COME OUT WITH FORECASTS OF SLOWER GROWTH WHEN WALL STREET'S CONSUMED WITH THE REPORT DU JOUR SUGGESTING THE OPPOSITE?
It's very hard. Everyone's asking, What do you mean? Then there are the data revisions. Who knows? Maybe you're right now and they'll revise the data later on.
DESPITE THE RISKS, ARE YOU CONFIDENT IN YOUR SLOWER-GROWTH FORECAST?
It's like a technical model for the stock market: this is what it says.
AND YOUR MODEL'S CLEARLY WARNING OF SLOWER GROWTH?
Yes, it is clear. It's saying, there's a slowdown coming. Now, the model I use looks at year-over-year data because there's so much noise in quarter to quarter. And there already has been a slowdown on a year-over-year basis in real GDP growth. What I'm arguing is that we've got more to go with that--even slower growth.
WHAT ARE THE ODDS THAT A SLOWDOWN COULD TURN INTO A RECESSION? IS THAT POSSIBLE?
It's possible. Real M2 growth on a year-over-year basis is less than it was when we went into the last recession. That's a negative. Yes, the spread between the 10-year and Fed funds is still positive, but barely so.
WHAT DO YOU ADJUST M2 MONEY SUPPLY WITH? THE CPI?
No, I use the PCE deflator--that's what the Conference Board uses in its leading indicator. On a quarterly basis, in the first quarter basis, real M2 was up only 1.7% vs. a year ago. Just before we went into the recession of 2001, by comparison, real M2 growth in the first quarter of 2001 year over year was 4.9%.
WHAT DO YOU MAKE OF MR. BERNANKE'S CLAIMS, COURTESY OF CNBC'S MARIA BARTIROMO, THAT THE MARKET'S MISPERCEIVED HIS COMMENTS?
Here's what I think Bernanke's saying: We've done a lot, but the full force of what the Fed's done in the past has yet to be felt in the economy. The Fed has a forecast that economic activity is going to be moderating, and that forecast incorporates some of the lagged effects. So even though the current data are relatively strong, the Fed's forecast is that things are going to slow down.
Bernanke's also saying that the Fed's impressed that the core rate of inflation has not materially spiked higher, despite the price increases in energy and other commodity prices. The Fed's impressed too that unit-labor-cost growth has been very well behaved, despite a very low unemployment rate. And the central bank appreciates the fact that inflation is a lagging economic process. That is, inflation turns down after the economy turns down, not before.
So, Bernanke's saying that the Fed would like to pause [with interest rate hikes] for a couple of meetings to see if in fact some of the new data coming in conform to its forecast of slower growth. If that's the case, then maybe the Fed will stay on pause. If it's not the case, and the economy's growing stronger than forecast, then the Fed will resume tightening.
So, that's what I think Bernanke's saying. Normally, the Fed keeps tightening until there's a downturn in coincident indicators--not the leading indicators. It's obvious to everyone that the Fed has overdone it, so the Fed is attempting not to overdo it this time.
YOU THINK A PAUSE WOULD BE THE RIGHT THING TO DO?
Yeah, well, I think there are a lot of other things that are the right things to do, but it's a second best I guess. Let me put it this way: If you're worried about overshooting, about putting the economy into a recession, then I think a pause at this point is a prudent thing to do. You may have other worries, other things you're concerned about. But if you're trying to balance the risks between inflation and recession right now, I think the risks of recession are moving up quite dramatically.
WHAT ABOUT THE RISKS OF INFLATION?
I'd have to say that the risk on inflation right now, because of rising energy prices, is somewhat higher. I'd also have to say that if we didn't have [high] energy prices in the mix, the risks on inflation would be lower.
Inflation is a very complicated economic process. By contrast, forecasting the economy, although difficult, is easier than forecasting inflation. Inflation has a much longer gestation period, according to some analysis I've done. That is, about three years between changes in the money supply growth and changes in inflation.
Nonetheless, I think the Fed has already put in place some disinflationary policies. Now, that could be disturbed somewhat by higher energy prices. But if you look through that, disinflation policies are in place.
DOES THE FED'S CHOICE BOIL DOWN TO NIPPING INFLATION IN THE BUD OR PREVENTING RECESSION? MIGHT IT COME DOWN TO ONE OR THE OTHER?
Yes, it might. And that's the history of the Fed. The history is that it produces a recession, and then with a lag the inflation comes down. I just wrote a piece on this, called Federal Reserve and Inflation Targeting--First Do No Harm. Because of the different lag structures, what the Fed ought to do is just concentrate on creating credit at a constant, steady pace. That wouldn't eliminate cycles, but it would mute the amplitude of the cycles.
But there's no way they're going to do that. Part of the problem with the Fed is that we've come to expect that the central bank can, by printing money, can cure anything, even the common cold, maybe. The Fed tries to get involved in stabilizing real growth and that sows the seeds of inflation down the road. Then the Fed starts to fight inflation, and that produces recession. If they would put things on automatic pilot, a steady state, we'd probably have some recessions, but they wouldn't be major ones. You'd have some inflation, but it wouldn't get out of hand and it would [eventually] come down. We'd get away from the boom-bust type of cycles that we have now. Granted, this has been an extended boom, and there are some special reasons for it. But in the longer run, we'd probably be better off if the Fed tried to fine-tune less.
WOULD INFLATION TARGETING, WHICH FED CHAIRMAN BERNANKE HAS EMBRACED IN THE PAST, BRING THE FED CLOSER TO YOUR IDEAL FOR MONETARY POLICY?
Inflation targeting to me doesn't mean anything until you tell me how you're going to do it.
THE DEVIL'S IN THE DETAILS?
Yes. And what I've written today suggests a way to do it with money supply growing at a constant rate, which over time gives you a fairly steady rate of inflation. Not only would it damp the amplitude of inflation in terms of consumer prices, it would also dampen asset price inflation, which I think is as harmful as consumer price inflation.
That said, sometimes housing prices should go up, sometimes stock prices should go up. The Fed doesn't know what the right price of a house or a stock is. So, it gets back to do no harm. Just print a certain amount of money and let everything else do what it will. That's a free market approach.
SOUNDS LIKE YOU'RE NOT A FAN OF CALLS FOR THE FED TO PRE-EMPTIVELY PRICK IRRATIONALLY EXUBERANT BUBBLES
You wouldn't have bubbles to pre-empt [with my approach]. The bubbles get created by easy central bank credit. If you don't have the easy credit to start with, then you don't get the bubble.
Posted by jp at May 4, 2006 10:21 AM
I'm not so sure 10s/FF or 30s/FF is such a great way to track what the curve is saying about future expectations...its alot more dynamic to use 2s/10s or 2s/bonds because of that element of inflation and future expectations. having said that, the recent steepening of the curve lends creedence to the fact that the Fed is now back in the drivers seat.
I think the conundrum is coming unwound and with it many carry trades and flattenening trades. The real story with the economy turns out to be profits. I think most of us expected profit growth to be in the mid to high single digits this year instead of the mid teens. With investment grade corporates and high yields debt trading so snugly to treasuries, that signals to me that there is not too much fear yet for slowdown in the intermediate term.
I know its cliche to say that housing will determine how much we slopw down and if we go into more of a slowdown than that, but I think its true. Its has been just to large a factor in the GDP growth since the last recession and the assett pump by the fed came into play. As the fed takes away that pump and lets the air out, I am going to be watching spreads to tell me what coming down the pike. 2s/10s and 2s/30s as well as high yield spread and corporates. I think the Stock market will chugg along for a few more months, but any fed pause or easing will not mitigate profit declines and we'll get a good pullback to the 9000 range.
When spreads begin to blow out we'll know whats real, and we know the fed watches those, and certainly the streets reaction to them...its just easier for us to monitor than when the fed gets in to the "only as good as the next economic release" phase, I would argue we are very close to entering once more.
Posted by: Hit The Bid at May 4, 2006 12:16 PM