The current pace of economic growth has “been worse than average,” the Center on Budget Policy Priorities laments today, although that didn’t stop the Federal Reserve from raising interest rates again today. In fact, the tax cuts of 2001 and 2003 were dispatched in vain, the think tank’s paper suggests, advising that “the economy’s overall performance does not make up for the adverse fiscal effects of the recent tax cuts or the unusually uneven distribution of the economic gains from this recovery.”

The numbers lend support for this view, CBPP reports. The average annual growth rate in gross domestic product after economic troughs in the post-World War Two era is 4.7%. The current recovery, thus far, measures only 3.3%, although that happens to be a bit higher than the 3.2% average posted for the 1990s.
Meanwhile, the current recovery rolls on, which is to say that the final chapter on the GDP-expansion experience in the 21st century has yet to be written. To judge by some of the more optimistic predictions, there’s still hope among some dismal scientists for acceleration in economic growth. Ethan Harris, chief U.S. economist at Lehman Brothers, tells clients in a research note that he expects America’s GDP in this third quarter will rise by 4.5%, up from his previous guess of 3.5%, Reuters reports today. And for the fourth quarter, he thinks the economy will advance by 4% vs. an earlier estimate of 3.5%. The catalyst for the fresh dose of bullish thinking? The “out-sized inventory destocking in the second quarter,” he explains.
Harris’ perspective is sanguine next to the 3.4% reported for the second-quarter rate of GDP expansion. But the bears are hardly an extinct species on the matter. Consider the latest Merrill Lynch downgrade for economic growth. The U.S. economy will expand by just 2.7% next year, down from a previous forecast of 3.2%. “Our revised outlook for 2006 is being premised on changes we are making to three key assumptions,” Merrill economists David Rosenberg and Sheryl King wrote in a report published Friday, notes The Globe and Mail. “Our oil price assumption, which we have taken higher to $50 from $40 (U.S.) a barrel, our dollar assumption has gone from a 4% decline to flat, and of course we bumped up our Fed funds forecast to 4% for the end of this year from 3.5% and the peak effect of that will show through in 2006.” The same article quotes Pimco’s Bill Gross has predicting recession “at some point in 2006/2007,” as he declared on CNBC last week.
So why is the Fed raising rates? Today’s 25-basis-point hike brings the Fed funds to 3.5%, the highest since the ill-fated month of September 2001. Nonetheless, by the central bank’s reckoning, 3.5% remains “accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity,” or so the Fed told us in a statement accompanying the rate hike. “Aggregate spending, despite high energy prices, appears to have strengthened since late winter, and labor market conditions continue to improve gradually.”
But if Greenspan and company expect the bond market to be impressed with the ongoing elevation in the price of money, today was something of a disappointment. The yield on the 10-year Treasury Note slipped a bit on the day, dipping ever so slightly to 4.4% in the wake of the Fed funds rise. As a result, the yield curve (to use the argot of the bond world) moved a step closer to inverting. That is, short rates moved nearer to long rates, with less than 30 basis points separating the current yields on a 10-year Treasury and its 2-year counterpart—that’s down from 180 basis points as recently as 12 months previous. If and when the two-year yield moves above the 10-year, the inversion of the yield curve will have arrived in all its ignominious glory.
Ignominious because an inverted yield curve has often signaled the approach of recession. But the warning’s not perfect, relates Richard Bernstein, chief U.S. strategist for Merrill Lynch. When it comes to corporate profits, however, the historical record’s clearer. “Although inverted yield curves do not uniformly forecast economic recessions, every inverted yield curve of the last 40 years has been followed by a profits recession,” he explained on July 25 by way of Reuters. Sometimes the profits decline occurred in as little as six months after the arrival of an inverted yield curve, although in one case it took as long as two years. The average lead time was 14 months.
No wonder that Larry Kudlow, host of CNBC’s Kudlow & Company, is calling for the Fed to cease and desist with its current strategy of monetary tightening. “The central bank has succeeded in removing most, if not all, of the excess liquidity they created following 9/11 and the vicious deflation that preceded the terrorist attacks,” Kudlow writes today in the National Review. “In my view, the Fed should declare victory and stop their auto-pilot restraining actions before they completely flatten or invert the yield curve.”
But such cries are falling on deaf central banking ears. The next opportunity for something different comes on September 20, the date for the Fed’s next regularly scheduled FOMC meeting.


  1. sludge

    I don’t claim to know much about economics– I’ve only taken intro to micro and intro to macro– but I’d like to bring up the point about the yield curve.
    As the article states, an inverted yield curve has in the past correlated with recession. But is it not confusing correlation with causation to through caution into the wind and to blindly insist that one must do whatever is necessary to uninvert the yield curve? Instead, isn’t the yield curve merely an indicator?
    I believe it is wrong to greatly continue to alter policy to try and make what is merely a measurement tool read properly when other economic indicators do not paint such a dismal picture.

  2. JP

    Yield curves by themselves don’t mean a lot. Rather, an inverted yield curve usually reflects a monetary tightening by the Fed. Eventually, if the Fed squeezes the economy, it’ll have an effect. Maybe that effect will manifest itself as a slower rate of growth, or the onset of the recession. Thus the all-important question: how long will the Fed continue to tighten?

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