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BY DOING NOTHING, IS FED POLICY REALLY GETTING TIGHTER?
Prepared by
The Northern Trust Company
As expected, the Fed left its funds rate target unchanged at 5.50% at the September 30 FOMC meeting. An article in the Sunday, October 5 New York Times suggested that even though the Fed left rates unchanged at the last FOMC meeting and had not raised interest rates since the 25 b.p. hike on March 25, monetary policy had been getting tighter. How could this be? With the consumer inflation rate falling, an unchanged fed funds rate resulted in a higher real fed funds rate. The Times article said that the real fed funds rate had risen from 2.2% in February to 3.3% in August–25 basis points of this increase came from the hike in the nominal funds rate and the rest came from falling inflation.
An increase in the real fed funds rate of 110 basis points in the space of six months does, indeed, sound like a significant tightening in monetary policy. The inflation measure used to get this quantum leap in the real fed funds rate was the all-items CPI, whose year-over-year percent change fell from 3.0% in February to 2.2% in August. But is this measure of consumer inflation the best one to use in calculating a real fed funds rate? A year ago, we would have thought so. But since then, we have done some experimenting with different measures of consumer inflation with which to deflate the nominal fed funds rate. We have found that a better predictive relationship between the real fed funds rate and real GDP growth is found when a core concept of consumer inflation is used to deflate the nominal fed funds rate than when an all-items concept is used. The decline in core CPI inflation between February and August has been smaller–20 basis points–than the decline in all-items CPI inflation–80 basis points. But even using core CPI inflation may overstate the increase in the real fed funds rate. The BLS has been tinkering with the CPI–both all-items and core–in recent years, which has served to lower both measures. But the BLS has not gone back to revise CPI data prior to when these adjustments were made. Thus, year-over-year percent changes in the CPI–all-items or core–are biased downward. The CPI is not a consistent time series.
As an unbiased core measure of consumer inflation, we use the chained Personal Consumption Expenditure (PCE) deflator excluding food and energy. The core PCE deflator is available only quarterly, so we can't make the same February-to- August comparisons as was done with the CPI measures. But we can say that core PCE inflation fell by only 10 basis points between the first and second quarters of this year. When using the core PCE deflator to measure inflation for real rate purposes, the real fed funds rate hit a cycle high of 3.3% in 1995:Q4, dropped back down to 3.0% in 1996:Q4 and rose back to 3.3% in 1997:Q2. And 25 basis points of the move from 3.0% to 3.3% was due to the hike in the nominal fed funds rate on March 25. So, in these terms, Fed policy has gotten only marginally tighter on account of falling consumer inflation.
We believe that the real fed funds rate is the lever of monetary policy. Monetary policy works by altering the public's spending-saving decision. Monetary policy slows down economic activity by inducing the public to spend and borrow less and to save and pay down debt more. And it is the real fed funds rate that induces changes in spending-saving behavior. But the problem with using the real fed funds rate to judge the restrictiveness of policy is that we do not know ahead of time at what level the real rate starts to “bite.” The real fed funds rate can trend up for an extended period of time before real GDP growth turns down on a sustained basis. All else the same, an increase in the real fed funds rate does represent a tightening in monetary policy. But all else seldom is the same. So, although a rise in the real rate of any magnitude implies a tighter monetary policy than if the real rate had remained constant or fallen, it does not necessarily signal a tight monetary policy in an absolute sense.
If a given level of the real fed funds rate is starting to “bite”–induce cutbacks in spending and borrowing–it would be reasonable to expect that bank credit growth would slow down. Bank credit represents the asset side of the balance sheet for the banking system. The M3 money supply covers the bulk of the banking system's liabilities. Because assets equal liabilities plus net worth, a change in M3 is likely to be reflecting a change in bank credit in the same direction. So, M3 growth is a proxy for bank credit growth. Thus, if a given level of the real fed funds rate is starting to “bite,” it probably will manifest itself first in a slowdown in real M3 growth. Major trend changes in real M3 growth usually are followed by major trend changes in the same direction in real GDP growth. Real M3 growth through the second quarter was accelerating, not decelerating. This suggests that the 30-basis-point increase in the real fed funds rate between 1996:Q4 and 1997:Q2 has not yet started to “bite.”
In part because of continued strength in real M3 growth, we do not expect much of a slowdown in real GDP growth after the third quarter s forecast 3½% annualized growth. We do expect some slowing, however, because of the severe weakness in the world's second largest economy and our second largest single-country export customer–Japan. Given the estimated retarding effects of the Japanese and Southeast Asian economic difficulties on our exports, we are assuming that real GDP growth will be in a range of 3% to 3¼% over the next few quarters. Although that represents a slowdown from the almost 4% annualized growth in the first three quarters of the year, we believe that this slower growth still is above the economy's long run potential growth. As a result, resource utilization rates, especially those pertaining to labor resources, will continue to rise.
The inflation model we wrote about in the September 25 Positive Economic Commentary suggested that marginally higher core consumer inflation for 1998 already was “baked in the cake,” so to speak. If the Fed does not act soon to slow aggregate demand, the probabilities of a mini boom-bust scenario developing in late 1998 would rise in our estimation. We have interpreted recent comments of Fed Governor Meyer and Richmond Fed President Broaddus as calls for near-term FOMC tightening. Fed Chairman Greenspan's October 8 testimony before the House Budget Committee suggests that he, too, is now leaning toward a near-term tightening. As a result, we are leaving in our forecast of a 25- basis-point increase in the fed funds rate at the upcoming November 12 FOMC meeting. In all candor, however, trying to pinpoint exactly when this Hamlet-like FOMC will actually take an action-step calls for as much training in psychology as in economics. Unfortunately, our formal studies were restricted to economics. The Fed claims to want to act preemptively. Our forecasts of economic activity and inflation suggest that a preemptive Fed ought to tighten now. The Federal Reserve Board staff is forecasting a mild drift up in core inflation in 1998, just as we are. Either the FOMC doesn't put much faith in the Board staff's forecast or the FOMC isn't sincere in espousing a desire to act preemptively. If we are close to the mark in our forecasts of economic activity and inflation but our timing is off with respect to Fed tightening, then we obviously will be off the mark–in the short run–in our interest rate forecast. But, again if our economic forecast is “in the ballpark,” then eventually so will our interest rate forecast, especially our forecast for interest rates on shorter-maturity debt issues.
October 10, 1997 Paul L. Kasriel and Asha G. Bangalore
The Northern Trust Company
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