Fed Funds: To Raise, or Not To Raise? John Ericksen

A string of recent surprises in employment, retail sales, and core inflation have created inflationary worries throughout the economy, driving bond prices to new depths, sending the stock markets on a wild ride, and turning the heads of federal funds speculators everywhere. A change in the target fed funds rate, once thought to be as far away as next year, suddenly looms closer on the horizon as inflationary worries have reignited. Despite these astonishing and surprising reports, slack still remains in the economy—slack that must be removed before inflationary worries have a strong case for moving the target rate. In order to remove this remaining slack and push the economy from an aided recovery to a self-sustaining one, the Fed must keep the target fed funds rate at 1 percent this May. However, the Fed must also continue to pay very close attention to the state of the economy. If the upcoming releases of GDP growth, the employment situation, and price increases all post strong gains, the Fed must be ready to move quickly to “tap the brakes” of the economy to keep things under control. While most estimates, including the federal funds futures market, indicate rates will not increase until August, a change at the June meeting may be a more correct action for the Fed to take. The Long Road to Recovery The most recent recession, beginning “officially” in 2001, marked the end of one of the longest periods of growth in American history. This recession, caused by a bursting tech-sector bubble, terrorist attacks on United States soil, numerous corporate accounting scandals, and war in Afghanistan and Iraq led to a GDP that performed well below its potential. The decreasing GDP led to decreasing corporate output and profits, which led naturally to a decreased need for employees. As unemployment increased and as the stock market suffered huge losses in many sectors income and wealth levels throughout the economy decreased. Interest rates began to fall, and the fear of deflation became a reality. People began spending less, leading to further declines in GDP. Businesses, striving to stay profitable, stopped borrowing from lenders.

All of these factors created a great deal of slack in the US economy. Capacity utilization—or the percent of industrial output currently in use—plummeted below the historic inflationary pressure level of about 80 percent. Businesses weren’t producing as much as they could, unemployment rates increased far above frictional levels, and price pressures, which previous to the recession had been leading to a moderate rate of inflation, were gone.

In order to stimulate the economy and increase capacity utilization, monetary and fiscal policy makers stepped in to try and pick up some of the slack, and they have done so with great success. In January 2001, the Fed began a 13-step reduction in the target fed funds rate, lowering the rate from 6.5 percent to 1 percent. By loosening monetary policy, the Fed was able to stimulate the receding economy. As interest rates declined, borrowing by businesses and consumers went up, especially in housing markets where mortgages were at historic lows. Spending—fueled by home equity lines of credit and lower prices—increased, leading to an increase in demand for goods. As

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the demand for goods strengthened, company output increased. Each of these factors contributed to the main goal of the Federal Reserve: picking up the economic slack caused by the recession. The falling capacity utilization rate halted its descent, and has begun to climb back towards optimal levels. Economic stimulation came from fiscal policymakers as well. In 2001, Federal tax laws changed with the 2001 Economic Growth and Tax Relief Reconciliation Act. Declining marginal tax rates and increased tax benefits for businesses were set in motion to decrease tax burdens. Hefty bonuses and refunds have done much to stimulate the economy to its current state. The Current Picture The stimulus provided by the accommodative monetary and fiscal policies has done much to propel the economy towards a self-sustained recovery. Also, the devaluing of the US Dollar has the potential to contribute to economic stimulation. As the value of the dollar has decreased, the amount of foreign exports has increased, due to greater buying power among foreign consumers. Unfortunately, this has been offset by increased imports and a widening trade deficit. Recently, however, the trade deficit has narrowed and the weak dollar may help to push GDP towards and above its potential. Equity markets, after the decline and revaluation caused by bursting bubbles and corrupt companies, have seen a sustained period of growth over the last year, with the S&P 500 index climbing 30 percent in 2003. Recent hesitations and uncertainties concerning the state of the economy have caused increased volatility; however, gains in the overall market have been positive and have increased investors’ wealth. Increased spending has ensued, also contributing to recovery. Banks have taken advantage of the long recovery to strengthen their balance sheets. With interest rates at a 46-year low, banks have readied themselves for growth. The relative strength of these lending institutions has also helped to push the economy towards a full-fledged and self-sustained recovery. However, we are not quite there yet. Due to a slowly growing labor market and super low inflationary pressures evident until just recently, the amount of slack left in the economy is still too large to pass over. Pricing pressure—the item monetary policy makers hope to control with the target fed funds rate—is still minimal in the economy, largely due to slack in capacity utilization. For the economy to be in full-fledged recovery, the slack created by the recession needs to be eliminated. One of the keys to eliminating this gap is sustained, above-potential growth in Gross Domestic Product, which is estimated to be between 3 and 3.5 percent.

The last two quarters have posted strong above-potential growth, and forecasters estimate that first quarter growth for 2004 will be in line with, if not above, last quarter’s growth of 4.1 percent. All indicators seem to sustain these estimates, some even signaling that the US may already be in full recovery. The ISM index continues to post very strong growth, and has in fact been over 50 since last June. Strong growth in the index for the first quarter of 2004 indicates that GDP will be strong indeed.

Productivity, a strength in the US recovery thus far, is also poised to contribute to a high first quarter GDP. A recent upward revision to the annual average rate of productivity growth indicates that the last two years have been the strongest two year period for productivity growth since the late 1940's.

The very loose monetary policy currently used by the Fed will be another contributor to a heightened GDP this quarter, as it has been in previous quarters. Businesses, currently sitting on huge piles of cash generated by soaring company profits, are beginning to use this cash instead of just holding it. Also, they have begun to take greater advantage of low rates, knowing that the strong growth seen over the last few months will cause rates to increase soon. Also, tax rebate checks will keep consumers and businesses happy, and will contribute to a high first quarter GDP. So, if GDP has grown so well, the ISM indicates continued strength, productivity is high, and fiscal and monetary policy both will do nothing but stimulate GDP this quarter, why not raise rates in May? Because it is just a bit too soon. For the economy to be in self-sustaining recovery, and to make up for lost ground in capacity utilization, above-potential growth is absolutely essential this quarter and next. If growth this quarter is strong, as estimated, the case for raising the fed funds rate will gain strength—but not enough strength to encourage the FOMC to change interest rates by May. For pricing pressure—which translates into rate hike pressure—to exist, there will need to be sustained growth over potential—something that has not been proven yet. By keeping interest rates at 1 percent just a little longer, economic stimulation will continue to strengthen the ISM and GDP, leading to a self-sustained period of GDP growth—which will in turn lead to a more adequate level of capacity utilization. Only then (and then may not be too far away) will pricing pressure begin to effect the economy and the target rate will need to be raised. The strong GDP growth evidenced in the last two quarters and expected in this quarter would normally be associated with strong labor growth. As companies increase output and profits increase, hiring follows shortly—except in the case of this recovery. During this recovery, the labor market has had a lot of economists scratching their heads in wonder and concern. While many indicators signaled an economy that was growing stronger and stronger each day, the employment situation remained stagnant and slack. Consensus indicates that the economy must produce 150,000 jobs a month to continue growing at potential, meaning that for self-sustaining recovery to be a reality, job growth will need to exceed that amount for a period of time. As shown, this has not been the case. The number of jobs created has lagged for quite some time, except for the huge jump in the recently reported March report. While the jump in jobs created in March was substantial, bringing the number of new jobs created this year to about 760,000, much must be done to recover the remaining 2 million jobs destroyed by the recession. As with GDP, slack in the labor market remains. Much of this slack has been due to increasing productivity. As productivity has increased, the amount that one worker can do has gone up and the need for more workers has decreased. This, coupled with business spending on machines and equipment rather than human resources, has kept labor markets below the necessary rate of growth. This slack, though, is debated. Many feel that the numbers being reported in the employment situation are too low, due to increasing numbers of jobs reported in household surveys, and the implied growth in jobs from both GDP and ISM increases. Indeed, the recent report of 308,000 jobs being created in March was accompanied by upward revisions to both January and February job growth. It can be assumed that more upward revisions will come and, as with the recovery in the 1990s, growth will be understated for a time. As such, the number of jobs being created at this point may be strong enough to carry the economy forward into self-sustained recovery without the

extremely loose target rate of 1 percent. Even if the numbers have not been understated, the peaking of productivity and the strong economic growth expected in the first quarter may be all this economy needs. But it may not be as well. With only two months of above-150,000 growth reported, the proposition that labor markets may be strong enough to carry the economy forward is not strong enough. The Fed must hold off a rate hike until after the May meeting to better ascertain the situation. Even if growth has been understated, it still has not been strong enough to warrant an increase in the target fed funds rate. However, as with GDP, the report to come out on May 7 must be watched closely. Keeping the rate low should help push GDP growth above productivity, which will increase hiring. If GDP has as strong a growth as expected, we should see strong labor market growth, and the time may be very close for the Fed to start slowly tightening monetary policy, as biases will indeed move from balanced to inflationary. Indeed, inflationary pressures may be very close. As GDP continues to grow and jobs begin to pick up, pricing pressure may become quickly evident in the economy. While there is much capacity left to be utilized in the economy before historical inflationary levels are met and pricing pressures become a problem, rising energy prices and stronger consumer and business confidence may lead to an early press on prices. Also, tax rebates will play a large role this month as many consumers begin to spend their larger rebates.

Wednesday’s report on the Consumer Price Index seems to solidify the fact that inflationary pressures may be coming earlier than expected. Gains in overall CPI were measured at 0.5 percent, rising slightly faster than February’s gains, but keeping the annual rate at 1.7 percent. The real surprise was the core rate of inflation which grew over the month from 1.2 percent to an unexpected 1.6 percent. Although much of the gain was attributed to lodging away from home and to rising apparel prices, rumors of inflating prices in all industries have made their way across the

nation. Bill Dunkelberg, chief economist with the National Federation of Independent Business in Washington has indicated that 43 percent of finance, insurance, and real estate service companies have raised prices, while none have cut them back. With GDP and unemployment on the mend, true pricing pressure may not be far away. But it isn’t here yet. While the recent CPI shows unexpected gains, one month’s report is not enough to fully remove the Fed’s estimation that the “upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal,” but they should be enough to nudge inflationary biases upward. The Producer Price Index, an index used to signal increases in overall inflation, also seems to indicate that inflation, while not an immediate threat, isn’t too far way. While February showed lower than expected growth, some areas of the index proved to be increasing quickly (especially among building materials such as wood and metal). According to the PPI, inflationary pressure is building, but has not yet appeared in force. Again, as GDP increases, consumer and business

spending rises, unemployment problems abate, and the trade deficit contracts, capacity utilization will again reach a level where pricing pressure is evident, and it may reach it soon. So, the FOMC must not raise rates just yet because the necessary growth has not yet occurred. In order to avoid stifling GDP and employment growth, the Fed must maintain their extremely loose policy for May. Again, although there may be room to breath now, careful attention must be paid to the May 14 report on CPI and the May 13 report on PPI. If upward pressure again rears its head, the Fed should act to increase the rate as soon as June. To Raise or Not To Raise? The United States economy is currently positioned on the fulcrum between aided and self-sustained recovery. While recent indicators have shown strong growth in the economy, the slack caused by the recession has not been fully removed. Though a change in the target fed funds rate at the upcoming meeting may have no effect on the economic expansion, there is a greater likelihood that an increase would tip the balance away from self-recovery. As such, when the Federal Open Market Committee meets on May 4, they must keep the target fed funds rate at 1 percent. The extension of this loose policy for at least six more weeks will help further stimulate the economy, and will give the Fed a little more time to observe economic conditions. However, because the economy is perched on the fulcrum of recovery, the Fed must pay very close attention to GDP, employment, and CPI over the next month. If strong growth appears again, the Fed should move the target fed funds rate as soon as June 29/30. Although capacity utilization will not be at its historic level, it does not need to be for the Fed to begin to tighten its policy. Because policy is extremely loose, starting sooner rather than later will avoid the need to slam on the monetary brakes should the need arise. It should be noted that a move in June is not expected by most markets. Before the surprising employment, retail sales, and CPI reports, federal funds futures markets were indicating a possible change in the target rate around year end. After yesterday’s report, the market currently is indicating an anticipated increase of 25 basis points in August, with two more increases of 25 basis points each coming in November and December. Also, yesterday’s news sent bond prices plummeting and yields soaring as the demand for bonds decreased due to expected inflation. The past three unexpected positive announcements have driven yield curves on bonds to new heights, as shown here. Due to the sensitivity of these markets to an unexpected rate hike by the Fed, the press release of the May 4 meeting should include wording indicating the possibility that a tightening of monetary policy may occur sooner rather than later.

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