HURRY SLOWDOWN*
Prepared by
The Northern Trust Company
*For our Gen X readers, this is a play on words of the title of a 1967 Otto Preminger film.
Although the Fed did not tighten policy this week, the minutes of the November 12 FOMC suggested that Greenspan and Co. still had tightening on its mind at that time. In fact, Richmond Fed President Al Broaddus felt so strongly about the need for tightening then that he formally dissented from the no-change majority decision. Did the Fed hold its fire on November 12 because it believed that the Asian upheaval would significantly slow down the U.S. economy? No. The FOMC chose not to tighten on November 12 because “a tightening of U.S. monetary policy risked an oversized reaction” given that the financial markets still were skittish at that time. “Some members also emphasized that the relatively favorable trends in productivity, costs, and prices continued to raise questions about the strength and timing of any pickup in inflation.” Although the FOMC did not tighten on November 12, it maintained its bias toward tightening.
As noted, the Fed did not tighten at the December 16 FOMC meeting either. Probably, the spread of the “Asian flu” to other countries in the region, most notably Korea, stayed the Fed's hand this past week. But U.S. economic data since the November 12 FOMC meeting has continued to come in on the strong side, for the most part. October consumption was robust and November motor vehicle sales rebounded. Employment shot up in November with the unemployment rate falling to its lowest level since 1973. Continued tight labor markets are starting to result in faster wage growth. Industrial production in the fourth quarter is shaping up to be a repeat of the strong third quarter output of our factories, mines, and utilities. The housing market remains robust. And exports were at a record high in October as the trade deficit narrowed. In sum, if the Fed didn't now sense that a powerful Asian economic headwind was approaching, it probably already would have tightened policy and we would be speculating whether the next tightening would be in early February or late March. The Fed and the debt markets are placing a huge bet on the fallout from Asia slowing down the U.S. economy and restraining inflation.
What if the Asian economic storm had not occurred? And what if the Fed kept the funds rate stuck at 5½%? What might 1998 real GDP growth look like under these circumstances? To answer that, we refer you to our proprietary GDP forecasting model. This model is “driven” by lagged values of variables related to monetary policy. It does not directly incorporate external shocks of the recent Asian variety. In Figure 1, we have plotted actual quarter-to-quarter annualized real GDP growth along with our model's forecast growth for the period 1967 through 1998. The forecast growth rates are based on the coefficients estimated through the fourth quarter of 1996. Actual values of explanatory variables are used to forecast 1997 real GDP growth. To forecast 1998 real GDP growth, we have assumed that the monetary conditions of the fourth quarter of 1997 will continue to prevail in 1998. As can be seen in Figure 1, our model is far from perfect in forecasting quarter-to-quarter GDP growth. There are some big forecast errors. But the model generally does a good job of catching major trend turning points.
Figure 2 contains the same data as does Figure 1, but for a shorter time period–1983 through 1998. We included Figure 2 just to “blow up” the picture for recent years and 1998. In 1997, our model underestimated real GDP growth in the first quarter and overestimated it in the second and third quarters. Our model is forecasting fourth quarter growth of 4.2%, which we believe also is an overestimate. But for 1997 as a whole, our model is forecasting real GDP growth of 3.8%, which we think will turn out to be about a tenth of a point above the actual. We would consider a tenth of a point forecast error close enough for private sector work. In the absence of an Asian effect and assuming current monetary conditions prevail in 1998, what would our model be forecasting for real GDP growth for next year? 3.7%.
The point of this exercise is to highlight just how important is the expected the negative effect on the U.S. economy from the Asian turmoil for the current interest rate structure. Built into this rate structure is the expectation that there will be no Fed tightening in the foreseeable future. Although official government statistics have yet to reflect any adverse Asian effect on the U.S. economy, some corporate earnings warnings have. If the Asian economic headwinds do not hit soon and are not of gale force, then our model suggests that there is going to be a radical windshift in debt market sentiment in the first half of 1998. We think that the Asian headwinds will reach us soon and they will be strong. But they will be countered by some very strong home-grown tailwinds. The net effect will be to retard the headway of the U.S. economy, but, by no means, come even close to stopping it.
December 19, 1997Paul L. Kasriel
The Northern Trust Company
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