We continue to think that the Fed will pause in its interest rate hikes at 4-1/2 percent. The reasons for this are that economic growth will be slowing significantly, starting in the fourth quarter (of 2005), and that inflation will be moderating. Under these conditions and recognizing that recent Fed interest rate increases have not yet had their major impact on economic activity and inflation, why would the Federal Open Market Committee (FOMC) want to push the funds rate higher than 4-1/2 percent? Moreover, although outgoing Fed Chairman Alan Greenspan has little practical use for the concept of a "neutral" fed funds rate, there is some evidence that incoming Fed Chairman Ben Bernanke does.
And the circumstantial evidence is that a 4-1/2 percent fed funds rate would be neutral, if not restrictive, under one of Bernanke’s criteria of fed funds rate neutrality.
How can we say that economic growth is slowing after quarter-to-quarter annualized growth of 4.3 percent in real GDP in the third stanza? Because we recognize that a lot of that third-quarter strength occurred in July and petered out thereafter. Real personal consumption expenditures, which accounted for almost three percentage points of third-quarter real GDP growth, grew at an annualized pace of 4.2 percent. But all of that consumption growth occurred in July. Real consumer expenditures fell in both August and September and increased by only 0.1 percent in October.
In order for real consumption expenditures to be just flat in the fourth quarter vs. the third, they would have to grow 0.5 percent in November and December. Although that is what we are forecasting, in all candor, we think that even flat real consumer spending in the fourth quarter is optimistic.
With consumption accounting for about 70 percent of GDP, it is the closest thing to a slam dunk in economic forecasting that real GDP growth in the fourth quarter will fall well short of third-quarter growth. In our estimation, the shortfall in growth will be 1.3 percentage points.
One quarter of slower growth, of course, could be just a temporary "soft patch." (In our view, Bernanke is a better economist than Greenspan but will fall short of his predecessor in phrasemaking.) But the Conference Board’s index of Leading Economic Indicators is signaling a sustained slowdown in real GDP growth going forward. On a Q4/Q4 basis, real GDP grew at 3.8 percent in 2004. We see it moderating to 3.6 percent in 2005 and to 3.0 percent in 2006.
Over the past 60 years, the compound annualized growth in real GDP has been 3.4 percent.
Making a conservative estimate of underlying productivity growth at 2-1/2 percent and assuming labor force growth of 1 percent, potential real GDP growth would be somewhere close to 3-1/2 percent. So, our forecast of 3.0 percent real GDP growth in 2006 would put it below both its long-term trend and a conservative estimate of potential.
This implies a rise in the unemployment rate in 2006. Why would the Fed want to keep raising the funds rate unless inflation were threatening to stay at its current elevated level?
We think inflation is more likely to trend lower in 2006 than trend higher. The spike in energy has been the primary contributor to the recent acceleration in consumer inflation. Moreover, core consumer inflation peaked in November 2004 at 2.3 percent and has been trending lower ever since.
Rightly or wrongly, the Fed has placed an emphasis on labor costs as a source of inflationary pressures. Is the labor market signaling higher inflation ahead? Hardly. After flaring up in the second half of 2004, growth in unit labor costs has settled down in 2005, with costs actually contracting in both the second and third quarters. So, with energy prices stabilizing, at the least, with core consumer inflation already trending lower, with labor costs behaving benignly and with aggregate demand in the process of moderating, which would relieve inflationary pressures, why would the Fed want to push the funds rate above 4-1/2 percent?
If our forecast of economic activity and inflation is close to the mark, another 50 basis points of increase in the fed funds rate at the very least would leave the Treasury 10-year yield around 4-1/2 percent and could easily result in a decline in its yield.
What does all this have to do with Bernanke’s view of the neutral level of the fed funds rate? We would refer you to a passage from a speech given by Bernanke on March 8, 2005: "The funds rate will have reached an appropriate and sustainable level when, first, the outlook is consistent with the Committee’s economic goals and, second, the slope of the term structure of interest rates is approximately normal, as best as can be determined."
With this definition in mind, one can search for indications of where the "neutral" funds rate is likely to be at a given point in time."
This statement by Bernanke shows that on March 8, at least, he, unlike his predecessor Greenspan, found the shape of the yield curve a useful leading indicator of economic activity. If Bernanke still believes this on March 28, 2006, the first FOMC meeting he will chair, and if the yield curve is flat, as we think it will be, then Bernanke is likely to conclude that a 4-1/2 percent fed funds rate is at least neutral and maybe even a little restrictive.
