Reply #55: Greenspan Has Spoken, China Is Revaluing And I'm Reevaluating

[54anickel]

http://www.gold-eagle.com/editorials_05/kasriel072605.html

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 (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 (www.northerntrust.com/library/econ_research/daily/us/dd072105.pdf). Chart 1 is 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" (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" 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".

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