Fed must raise rates to keep the lid on inflation
Monday 16 September 1996
After encouraging inflation data, the world's financial markets on Friday clearly came to the view that the Fed will once again leave rates unchanged. Yet the decision is likely to be a close-run thing, and even if nothing is done next week, the pressures for a significant tightening in monetary policy before the end of the year are becoming irresistible. The basic case for a rate rise is that the economy is already working at above its normal level of capacity; that it is also growing at more than its trend rate; that the existing setting of monetary policy is not tight enough to depress GDP growth to below trend; and that early warning signals of inflation pressure are already very evident in the labour market. Let us consider each of these factors in turn.
The normal level of capacity in an economy depends on a combination of the level of unemployment relative to its natural rate, and the rate of utilisation of plant and equipment. Both of these concepts , as ever in economics, are subject to some ambiguity. A comprehensive study published by the National Bureau for Economic Research this year by Messrs Staiger, Stock and Watson (NBER Working Paper 5477) came up with a central estimate for the natural rate of unemployment in the US of 6.2 per cent. They also said they could be 95 per cent certain on statistical grounds that the true rate lies in the range 5.1-7.7 per cent. The level of actual unemployment today is 5.1 per cent, exactly at the bottom end of this range, which means we can be 95 per cent certain it lies below the natural rate.
Turning to plant capacity, utilisation rates have dropped slightly in the past 12 months, but remain well above their historical average. Taken together, the fact that unemployment is below its natural rate, and plant capacity is above average, must inevitably imply the level of GDP is above equilibrium. Sure enough, the latest estimate from Goldman Sachs shows GDP in 1996 will be about 0.9 per cent above trend, which implies inflation pressures in the economy should already be rising. Furthermore, in recent months the growth rate of the economy has been running at 3-4 per cent, well above the long-run trend rate of 2 per cent. Therefore, the gap between output and trend is widening when it should be doing the opposite.
Optimists would claim there are already grounds for believing the economy is slowing. Consumer spending has not maintained the break-neck pace of growth seen earlier in the year, and some consumers appear to be curtailing borrowing in response to rising debt. Furthermore, they say, the investment cycle is overdue for a sharp downturn following the strength of recent years. But none of this is convincing.
The increase in consumer debt has been swamped many times over in the past 18 months by the increase in household assets, driven largely by an equity market up by about 50 per cent in 18 months. By no means has all of the resulting rise in household wealth yet impacted on consumer spending, which is probably taking only a temporary breather after being boosted by large tax rebates in the spring. Meanwhile capital spending stays surprisingly strong. As the graph shows, the manufacturing sector seems to be emerging strongly from the mini-dip that occurred last winter.
Economic upswings do not, in general, die naturally of old age. They die of inflationary excess, followed by the tightening in monetary policy which is necessary to cure that excess. So far, none of this has happened. On almost all measures, monetary policy is no tighter than neutral. True, the real short-term interest rate stands at around 3 per cent, while the historical average is only about 2 per cent. But there are reasons for believing the "neutral" real rate has risen compared with its historical average, including the lifting of interest rate ceilings in the early 1980s, and the strong rise in public sector debt throughout the past two decades.
Other symptoms of tight money are clearly absent. Growth in broad money (M2) is near the top end of its target range. Equity prices hit new highs every time the markets become optimistic that the Federal Reserve might not raise rates, as we saw with the surge on Wall Street last week. (So much for the view that the central bank can stand back and let the financial markets do the work of contracting the economy all by themselves.) And the Goldman Sachs Monetary Conditions Indicator, which combines the levels of short rates, long rates and the dollar, suggests the present stance of overall monetary policy is a little easier than it has been on average over the past decade.
The upshot of this is that policy has not yet been tightened enough to puncture the long upswing in economic activity which started in 1991. Now that output is clearly above trend, inflation pressures are likely to build gradually until the Fed has tightened enough to bring the growth rate in GDP down to 2 per cent or less. The longer it waits to do this, the greater the inflationary pressure which will subsequently need to be squeezed out of the system.
It is at this point that the optimists play their trump card. The trend rate of growth in the economy, they claim, is no longer around its historical average of 2 per cent, but has risen to 3 per cent or more as a result of the favourable supply side changes within the US economy, and the competition from unskilled workers in emerging economies which has reduced the natural rate of unemployment. It is indeed possible that both of these factors have been at work to a limited extent, but the acid test is whether inflation pressures have in fact started to rise since output moved above traditional estimates of "trend".
The news here is mixed. Consumer price inflation has not really budged up or down for several years now, and seems to be benefiting from the intense competitive pressures which exist in the American retail sector. But in the labour market wage inflation is clearly rising. After troughing at 2 per cent in 1993, hourly wages are rising at a rate of over 3.5 per cent. Furthermore, the Fed's own "Beige Book", which reports on business conditions around the US, took the unusual step last week of promoting to the front of the publication a sharp warning that wage pressures are rising in many parts of the country. If the Fed heeds the warning of its own staff about wage pressures, then it really should tighten policy next week.
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