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For the Fed, it's about growth, not inflation

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Demeter Donating Member (1000+ posts) Send PM | Profile | Ignore Sun Aug-20-06 01:43 PM
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For the Fed, it's about growth, not inflation
http://www.marketwatch.com/News/Story/Story.aspx?guid=%...


Two economists agree on only one thing: If economy slows, the Fed will cut
By Rex Nutting, MarketWatch
Last Update: 3:48 PM ET Aug 19, 2006


WASHINGTON (MarketWatch) -- It's growth, not inflation, that will determine when the Federal Reserve begins to cut interest rates, according to two Wall Street economists who have very different views about the timing of that first ease. Benign inflation data released last week seemed to persuade financial markets that the Fed's next move will be to cut overnight interest rates, probably early next year. But economists Jan Hatzuis and Ethan Harris say the Fed won't cut rates until growth slows significantly. Inflation will have little to do with the decision. Hatzius, chief U.S. economist for Goldman Sachs, says the first cut will come sooner than many expect, probably in the first quarter of 2007. Why? Because the Fed always acts quickly once the unemployment rate begins to rise.

"If Fed officials aim to avoid recession, they should ease aggressively as soon as the labor market starts to weaken," Hatzius wrote in his weekly note to clients. Since the mid-1960s, every time the unemployment rate has increased by even one-sixth of a percentage point, the Fed has eased, the Goldman economist said. And Hatzius thinks the labor market is already beginning to weaken. The Fed's threshold to begin cutting is two or three quarters off, he said. That's a major reason why Goldman is predicting that the Fed will aggressively cut rates from 5.25% to 4% by the end of 2007.

By contrast, Harris, the chief U.S. economist for Lehman Bros., thinks the Fed will raise rates two more times to 5.75%, then hold rates steady for a year or so before the first quarter-point cut to 5.50%, likely in the fourth quarter of 2007. Why? Because the economy is not slowing enough to force the Fed to cut rates. And because inflation is still accelerating. "A rate cut today would probably require that growth slip toward 1% and core inflation to show clear signs of turning down," Harris wrote in his weekly note.

To forecast Fed actions, many economists use a version of the Taylor Rule, a formula created by economist John Taylor a decade ago that seemed to explain what the Fed has actually done. In the Taylor Rule, the Fed faces an explicit medium-term tradeoff between growth and inflation.
To reduce inflation, the Fed must push growth below trend for an extended period. If trend growth is 3%, it would take a year of growth less than 1.5% to bring the inflation rate from 2.5% back to 2.0%., according to Taylor Rule calculations by Hatzius. But the Taylor Rule is a simplistic view of the Fed, Hatzius said. The Fed actually is very sensitive to slower growth. Fed policy is "non-linear," he said. "The U.S. economy historically has had an extremely difficult time sustaining below-trend growth without falling into recession," Hatzius said. A recession has ensued every time the three-month average of the jobless rate has risen by a third of a percentage point, he said.
Harris likely agrees with that analysis, to a point, he just doesn't think the economy is slowing in a meaningful way. "If growth dips below 2% and the unemployment rate starts to trend higher, the Fed may decide to ignore any further pick-up in core inflation," Harris said.

Ironically, the more the financial markets expect a slowdown, the less likely to is, because the recent rally in the stock and bond markets has undercut the Fed's efforts to slow the economy by providing more stimulus. The only financial drag on the economy is the housing market.
"So it boils down to one simple question: Will the housing correction on its own crush the economy?" Harris says. His view is clear. "We find it hard to accept the more dire housing stories." A soft landing is more likely, with housing slowing -- but not stopping -- economic growth,
Housing is the key to Hatzius's forecast as well. "The termites are eating away at the economy's foundations," he said.





Rex Nutting is Washington bureau chief of MarketWatch.

READING THE TEA LEAVES--SOUNDS LIKE THE GRIM!
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