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September 18, 2005
Picking up the (measured) pace?
Read Tim Duy's remarks at Economist's View:
I'll quote from the conclusion because there's something worth your consideration. Pay particular attention to the last paragraph. The previous two provide the context.
But what about consumer confidence? The UMich Index saw a dizzying slide in September (WSJ subscription only) from 89.1 to 76. The question, however, is to what degree Katrina and gasoline impact consumers’ willingness to spend. This is different from the ability to spend. Consumers may be unhappy because the basket of goods they can purchase has shrunk (or is increasing more slowly), but that doesn’t mean they stop spending. Indeed, non-auto retail sales gained 1% in August – an annualized rate of over 12%! Even if a big chunk of that gain was gasoline, the will to spend remains intact.
A more concerning event would be for consumers to be scared into abruptly raising their savings rate. So far, we have seen little evidence that households want to hold onto a bit more of their paycheck. And even if they did, to what extent would that really change Fed policy? To be sure, many would be calling for the Fed to stop and even reverse course, but higher savings rates will be a necessary part of the rebalancing that (I believe) the Fed expects will happen at some point. Remember, the US is currently consuming roughly 6.4% (the current account deficit) more goods and services than it produces. I doubt anyone at the Fed believes such a situation can continue indefinitely.
In practice, I suspect that rebalancing will require slower demand growth to eliminate this gap – implying a risk that the Fed will raise rates higher in a deliberate attempt to hold growth lower than at any time in recent memory. I think this will come as a surprise to many, but in my opinion the Fed has been sending signals left and right that a change is coming. And, if estimates of potential growth are falling as well, as I read into San Francisco Fed President Janet Yellen’s speech last week, that change may be coming sooner than expected.
So I re-read Yellen's speech. Yes, she talks about the revisions to productivity growth. Here's a quote. You decide what it means.
Recent data revisions lowered estimates of productivity growth over 2001 to 2004 somewhat and reveal a deceleration in productivity growth over the past year or so. These revisions probably warrant a modest decrease in our estimates of structural productivity growth—the underlying noncyclical portion of productivity which is most relevant in assessing inflationary pressures. That said, it's very encouraging that even after a downward adjustment, structural productivity still appears to be growing somewhat faster than the robust rates achieved in the second half of the 1990s, and it remains quite strong by historical standards.
"Faster than the robust rates achieved in the second half of the 1990s" does not suggest enough of a revision to warrant a significant slowdown. If we are really talking about a quarter of a point drop in the growth of potential, do we believe we know enough about the effects of the increases already in the pipeline and those that are coming to be able to say with confidence that we should pick up the pace of rate increases? Consider also that capacity utilization is not yet at late 1990s levels (see Kash at Angry Bear)
So I'm curious as to whether Duy thinks the pace of increases will actually quicken, or the (as yet unstated and rather nebulous) target has shifted up, or both. I'll lay my cards on the table that I could very well see a shift up of the target--what the Fed would consider a "neutral" funds rate. But I'm nervous about quickening the pace just yet. As gas prices retreat from the post-Katrina spike, expectations should hopefully come back in line. It's clear were the interest rate trajectory was going before Katrina. The argument to shift to a higher trajectory is not compelling to me right now, whereas a shift to a higher target (at a "measured pace") is certainly reasonable. Such a view would not preclude a pause if growth slows suddenly, as long as we're clear that it is a pause and not a stop.
Duy also writes:
David Altig notes that the previous outlier in inflation expectations was a short-lived but sharp drop following 9/11. It is worth remembering that the Fed followed the attacks with aggressive rate cutting. Wouldn’t the appropriate strategy now be the opposite?
Not necessarily. The immediate and urgent response of the Fed to 9/11 is more attributable to the provision of liquidity to head off the potential for systemic risk in the financial markets. That they then held rates so low for so long after inflation expectations returned to normal is seen by many as fueling the housing bubble and perhaps the incipient rise in inflation now rearing its head. To be sure, the risk to the financial markets post-9/11 posed some unusual concerns and the immediate response was probably the correct one. But given the known difficulties in changing the course of policy, the risk of overcorrection is great. I would be very cautious about applying such a policy change with urgency in the present setting unless there is evidence that the change in inflation expectations is not a blip and not an over-reaction to the temporary gas price spike. If expectations stay this high for a month or two, all bets are off. If they come back in line, stay the course.
Posted by William Polley at September 18, 2005 4:31 PM
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Comments
William:
You are right, it is a nebulous target. And I think that the upper-end and midpoint of that range has likely increased. I also agree that it is too early to be thinking 50bp increments.
The 1/4 point shift in the potential growth rate may seem insignificant, but such subtle directional shifts build up over time. In the late 1990's, many believed that Greenspan saw potential growth running at 4-4.25%. That is a long way from 3.25%.
Tim
Posted by: Tim Duy at September 19, 2005 10:31 AM
Tim,
We're in basic agreement then, though I suspect I would be more comfortable with some form of pause in the next few months than you might be.
Of course if these inflation expecations were not a blip, all bets are off.
Some of the people who think Greenspan saw that sort of growth in potential GDP also think it led to the stock market bubble. Clearly 4% was wrong, but I'd hate to be just as wrong in the other direction.
Thanks for stopping by!
Posted by: William Polley at September 19, 2005 11:50 AM
Isn't the problem with the consumer survey results is that to a great extent they are internally inconsistent.
If retail sales growth drops sharply, as the
confidence number imply, then the changes of significantly higher inflation should moderate
rather then increase.
Right ?
Posted by: spencer at September 19, 2005 2:20 PM
If people are reacting to oil (and more generally, energy) price shocks, it is not necessarily inconsistent. How much of what we are seeing (and how much of the consumer reaction to what we are seeing) is demand related and how much is supply related?
There's a lot more to it, of course (namely, expectations about what the Fed is going to do--those expectations are in flux--and what impact all this new federal spending will have, etc.), but that's the main idea.
Posted by: William Polley at September 19, 2005 2:39 PM