Goldman Sachs Economic Update

The recent economic data clinched the case for the FOMC to start its tightening campaign at the June 29- 30 FOMC meeting. Compared to past tightening episodes, the game plan is clear because Fed officials have been forthcoming in their thinking. Assuming no unusual data surprises, Fed officials plan to tighten at a measured pace, with a series of 25-basis-point moves the most likely outcome.

 
 

he recent economic data clinched the case for the FOMC to start its tightening campaign at the June 29- 30 FOMC meeting. Compared to past tightening episodes, the game plan is clear because Fed officials have been forthcoming in their thinking. Assuming no unusual data surprises, Fed officials plan to tighten at a "measured" pace, with a series of 25-basis-point moves the most likely outcome. As a result, uncertainty about the federal funds rate path pertains much more to 2005 than the next six months. How far the FOMC will have to go and how long it will take to get there remain uncertain. Our view remains that Fed officials will take a break from the tightening process after, perhaps, four 25- basis-point moves.

The notion is that the economy is likely to slow in response to tighter financial market conditions and other factors, such as the ongoing shift in fiscal policy, that restrain consumer spending. Such a break in the tightening process would then cause financial conditions to ease and the economy to strengthen anew, setting the stage for a revival of the tightening campaign during the second half of 2005. In our forecast, the federal funds rate only rises to about 2.50% by the end of 2005, but with further tightening likely in 2006. However, if real GDP growth stays elevated and productivity growth falls sharply, then this view would probably be wrong. Pressure on resources would build more quickly, necessitating a less measured approach to tightening monetary policy.

Transparent and Measured
The conduct of monetary policy has changed significantly since the 1994-1995 tightening episode. Fed officials are now transparent in their intentions. They expect the tightening process to be "measured." In contrast, a decade ago, Fed officials were much more guarded in sharing their thought process and unwilling to strongly foreshadow a particular path of monetary policy tightening. The shift in Fed policy toward transparency presumably stems from the growing dominance of the capital markets in the US financial system. The share of credit market debt (including loans) held directly by depository institutions has shrunk over the past few decades.

Similarly, the US equity market has also increased in its importance. Equities have climbed to about 42% of household financial assets, up from 25% in 1980. The proportion of households owning stocks and mutual funds has also increased sharply. Finally, the valuation of the dollar has become more important as the economy has become more open. The combined share of exports and imports relative to GDP has climbed to 24.4% from 9.5% in 1960. As a result, monetary policy has come to be transmitted mainly by shifts in financial market conditions-the level of short- and long-term interest rates, the level of equity prices, and the value of the dollar.

This means that it has become more important that the markets "get it right" about Fed policymakers' intentions. Otherwise, the monetary policy impulse will be subverted by movements in the components of financial market conditions that are inconsistent with the FOMC's intended path for the federal funds rate. In this regard, Fed officials have to be pleased about the recent tightening of financial market conditions.

The FOMC's intention that monetary policy tightening will be "measured" reflects five major considerations.

First, with financial conditions now tightening ahead of the rise in short-term rates, shifts in monetary policy work faster, making it less important that Fed officials act preemptively.

Second, the low level of inflation also means that there is no need for monetary policy tightening to be preemptive. For example, if the FOMC's implicit target for the core PCE deflator is a range of 1% to 2%, then the core PCE deflator should be allowed to rise to the top end of this range (if not slightly beyond) by the end of the economic expansion. The era of "opportunistic disinflation" in which Fed officials kept inflation in check during expansions and reaped disinflationary dividends during economic downturns has passed-at least temporarily-because Fed officials have achieved their inflation objective.

Third, Fed officials plan to be "measured" because they believe that the economy still has "appreciable" slack. As a result, most members of the FOMC believe that the recent uptick in inflation-to quote Governor Kohn-"probably does not represent the leading edge of steadily worsening inflation."

Fourth, there is considerable uncertainty about how the economy will respond to the tightening of financial conditions provoked by monetary policy tightening. This is an atypical expansion. There is little pent-up demand among households. Instead, the household financial balance-the difference between household income and spending-is unusually depressed right now. This balance stood at -2.2% of GDP in the first quarter, about 4.4 percentage points below its long-run average. Past post-bubble experiences suggest that the central bank should proceed cautiously. In similar circumstances, premature tightening pushed the US economy back into recession in 1937 and Japan back into recession in 2000.

Fifth, the 1994 experience presumably has made Fed officials more determined to anchor market expectations about the likely magnitude of tightening.

Although the 1994-1995 tightening episode ended happily for the Fed with a soft landing, it was not without its scary moments. In particular, market participants priced in considerably more tightening than Fed officials ever contemplated. This tightened financial market conditions and increased the risks of an inadvertent hard landing. As shown in Exhibit 4, Eurodollar futures yields climbed to levels more than 200 basis points higher than the 6% peak in the federal funds rate.

How Much Tightening in 2005?
The outlook for 2005 is very cloudy. It depends on the strength of the economy, how much this tightens up the labor market, and the consequences of this tightening for wage compensation and price inflation.

 

 

 

June 21, 2004


Comments

 
 
 
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