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Danny Gabay: When the Fed stops its neutral talking, we'll know the squeeze is about to be applied
20 February 2005
Once upon a time, Alan Greenspan, the Federal Reserve chairman, revelled in his ability to leave his audience none the wiser as to what he had just said. He famously once told Congress: "I guess I should warn you, if I turn out to be particularly clear, you've probably misunderstood what I've said."
But make no mistake, Mr Greenspan is a man who knows the power of words, particularly his own. In fact, in recent years, he and his colleagues at the Fed have become rather adept at nuancing their message in order to elicit a desired response from the bond market.
At his biannual testimony to Congress on the state of the US economy last week, Mr Greenspan noted that despite six successive quarter-point increases, US interest rates remain "relatively low". That may not sound like much to get excited about. But it was enough to send the bond market into a tailspin, pushing up interest rates across the world. The implication of his comments is that interest rates have a way to go. The question for the bond market and US consumers, is how much further?
Before exploring this issue, we should first set out why interest rates are rising at all. The period of extraordinary global liquidity ushered in by the first cut in US interest rates in 2001 is coming to an end. Having pushed interest rates down to exceptionally low levels globally, central banks are now engaged in the process of removing that liquidity. Unless rates rise globally, inflation - that double-headed demon of the 1970s and 1980s - might be unleashed again. Do not listen to those who speak of the death of inflation: if it were a bear, it would simply be hibernating.
This is perhaps most evidently true for the United States.
Last year, US inflation reached its highest level in four years, and it shows no sign of slowing down. Indeed, the evidence from the early stages of the price pipeline is that inflationary pressures are mounting, not abating.
The falling value of the dollar is exacerbating this inflationary impetus. As the currency weakens, it pushes up the price of imported goods and services to US consumers and businesses. That not only fuels higher inflation but also inflates the already record trade deficit the US runs with the rest of the world.
So how high will US interest rates have to go to stabilise inflation? The answer to this question depends crucially on the concept of a neutral interest rate. That is usually defined as the interest rate that would neither stimulate nor restrict inflation; the implication being that for any economy, there exists a rate of interest which will stabilise inflation at a desired level. This rate is traditionally given by adding the desired inflation rate to the underlying or trend rate of growth in the economy.
Hence in the UK that would imply a level of between 5 and 5.5 per cent, compared with the current rate of 4.75 per cent.
In the US which has a stronger underlying rate of growth, it could imply a rate above 6 per cent.
However, this may oversimplify the issue. For one reason, while the UK does appear to conform to economic theory, the US does not. The first chart above shows that over the past hundred or so years, the average real interest rate in the UK has been more or less equal to the average rate of growth in the economy. But in the US the real interest rate has tended to be much lower than growth, perhaps reflecting the dollar's role as a reserve currency.
More importantly, a distinction should be made between the natural real interest rate - the rate at which the returns to saving (or investment) and consumption are equal - and the neutral real rate of interest, that at which inflation is stabilised. The former should be largely unaffected by the economic cycle, while the latter will vary over time with the economic cycle. This distinction could have important implications for investors and mortgage holders, as there will often be reasons for a gap, sometimes a significant one, to exist between estimates of the two concepts. We would argue that it is the neutral rather than the natural rate that should matter the most for monetary policy.
Policymakers recognise this distinction. But of course, no central bank claims to know for certain where the neutral rate is, so policymakers will often characterise the current level of interest rates as either stimulative (ie below the neutral rate) or restrictive (above the neutral rate). In essence, the central purpose of monetary policy is to increase or decrease interest rates, depending on what is appropriate, relative to some measure of the neutral rate. The actual interest rate should be below neutral when the economy is weak and above it when it is strong.
The gap between the actual interest rate and the neutral rate is therefore a measure of how restrictive or loose monetary policy is. Right now, we would argue that US monetary policy is too loose. We have derived an estimate of the real neutral rate using an empirical model.
The second chart above shows how our estimate of the neutral real interest rate in the US has evolved relative to the actual interest rate since 1985. After rising in the late 1990s, the neutral rate has fallen back since 2000. To some extent, this has reflected the decline in the average inflation rate over the same time. But the successively lower peaks may also indicate an improving output-inflation trade-off. Hence the neutral US policy rate may now be as low as 4 per cent. That is a good deal lower than the more simplistic estimate of the natural rate, but given recent inflation readings, neutral may no longer be enough. But remember, the first hint that the Fed is getting worried will come via its words rather than its actions.
Danny Gabay is a partner at Fathom Financial Consulting,
www.fathom-consulting.com
Thank heaven for American consumers
Much is made, particularly in Europe, of the potential threat to the global economic system posed by America's seemingly insatiable appetite for consumption, and its apparent antipathy towards saving. The US runs a huge deficit on its trade with the rest of the world, while its government runs a huge budget deficit. Neither deficit is sustainable. Both are a source of concern. But not, perhaps, as much as some would have you believe.
Having inherited a small surplus from the Clinton administration, George Bush has plunged the budget into the red, to the tune of over $400bn. But he has now unveiled a plan to halve this deficit by 2009, largely by cutting funding to some 150 federal programs.
It is an ambitious plan. But by far the most controversial aspect of the package is the proposed partial privatisation of the social security fund. Since its inception in 1935, the US social security system has included a trust fund from which payments are made. It has until now been in surplus - that is, contributions have outpaced payments. But this is set to change.
The non-partisan Congressional Budget Office argues that by 2020 the fund will be in deficit. The proportion of those over 65 is set to double by 2050, while those in work will only increase by 20 per cent. Hence, the situation will only get worse. The Bush plan is to allow individuals to set up private accounts to save for their own retirement.
This amounts to a partial privatisation of the fund and is likely to meet with stiff resistance from the Democrats. But it is a first step in recognising that there is a problem. And that contrasts sharply with the ostrich-like approach of the Japanese and several European governments, which face a far more acute problem.
Turning to the trade deficit, it is true that Americans consume too much. They live beyond their means and are reliant on the rest of the world's savings to finance that consumption. But it is also true that without those American consumers, there would be precious little growth around.
While the British and French economies are performing well, the eurozone as a whole remains weak. German growth is still an oxymoron, while Japan has quietly slipped back into recession - its third in four years.
Until these economies can begin to generate their own domestic demand, we should be grateful for America and its consumers.
20 February 2005 08:09
