U.S.: One More Rate Cut--Maybe. But Then What?

Rising productivity and weak labor markets will delay Fed tightening

In one of the most aggressive policy moves ever, the Federal Reserve cut the federal funds rate from 6.5% at the beginning of 2001 to 1.75% at the start of 2002--and another cut on Jan. 30 cannot be ruled out. Now, just as this massive stimulus is fueling prospects for recovery, a key question has cropped up: When will the Fed begin to raise interest rates?

Rest easy. Policymakers are unlikely to be in any hurry to reverse course. A subpar recovery, rising unemployment, declining inflation, excellent productivity growth, and plenty of production slack will keep the Fed on the sidelines for a long while. Recent speeches by a raft of Fed officials strongly support this view.

Even so, with the funds rate now below inflation, implying a negative real rate, monetary policy is exceptionally accommodative to economic growth. At some point, the Fed will want to nudge interest rates back up to a level that gives policy a more neutral stance.

Investors, well aware that Fed actions affect stock and bond prices, are already anticipating a reversal in monetary policy. Yields on 2- to 10-year Treasury securities are up substantially from November, mainly reflecting expectations that the coming recovery will cause the Fed to lift rates, along with prospects for increased Treasury borrowing to fund budget deficits. Plus, contracts on interest-rate futures reflect bets that the Fed will begin to tighten as early as summer and that rate hikes could total more than one percentage point by yearend.

Those expectations sound a little too aggressive, however, given the outlook for rising productivity and low inflation. Most important, history shows that the Fed does not tighten until the jobless rate begins to decline. In this recovery, that may not happen until late this year. As a result, the Fed may not begin to lift rates until the fourth quarter.

THE GOOD NEWS on the labor front is that the December employment report suggests that the worst of the job losses are probably over (chart). Private-sector payrolls fell by 187,000 last month, less than the 465,000 jobs lost in October and the 382,000 shed in November. Also, manufacturers sharply increased their workweeks and overtime. That's a typical recovery event: When demand first begins to strengthen, factories work their existing employees for more hours before hiring new workers. So December's longer workweek suggests a firmer tone to the factory sector (chart).

Still, don't expect much from the job markets. Companies will probably choose relatively cheap capital over more expensive labor as a means of boosting output and profits. That's why payrolls will not grow rapidly in the early stages of the recovery, and the jobless rate, which rose 0.2 percentage points in December, to 5.8%, is destined to rise further and then be very slow to come back down.

Weak labor markets are another reason the Fed will be less apt to raise rates. Of course, the jobless rate is politically sensitive. But more important, consumers will not provide the same thrust they usually do in a recovery. First, household spending did not fall off as sharply as it usually does in a recession, leaving less pent-up demand to be filled as better times emerge. Second, this year will see the pendulum swing back toward corporate profits and away from wages.

Remember that profits' share of national income surged in the mid-1990s--as business investment spurred productivity growth and thus corporate earnings--and that labor's share of income ebbed. By the late 1990s, the trends had reversed: Unsustainably high economic growth tightened labor markets. That lifted household income but also raised costs and squeezed profits.

NOW, IT'S CORPORATE AMERICA'S TURN to gain ground at the expense of Household America. Continuing cuts in variable pay and bonuses, along with the sharp cutbacks in contingent workers, are all reflections of this shift. And as demand picks up this year, companies will restore their profit margins by boosting productivity, not payrolls.

Given the spread of technology in the economy, it probably comes as little surprise that productivity growth is holding up phenomenally well in this recession. And it will grow even faster as the recovery gains speed. That resilience was especially true in the fourth quarter of last year. Official data will not be available until Feb. 6, but productivity appears to have posted a solid gain. Hours worked last quarter fell at a 3.9% annual rate. Even if real gross domestic product fell 2%, as is generally expected, productivity would still post a gain in the 1% to 2% range.

In the first three quarters of this recession, productivity is on a track to grow at a 1.9% annual rate. That's on a par with the 1.8% pace during the same period of the recessions of the 1950s and 1960s, a time of generally high productivity growth. And the trend is in sharp contrast to the recessions from the mid-1970s to the early 1990s, when productivity fell off sharply from its long-term growth trend. In that era's three recessions that lasted at least a year, productivity declined at an average annual rate of 0.9% during each downturn's first three quarters (chart).

THE UPBEAT PRODUCTIVITY OUTLOOK will be central to the Fed's way of thinking in 2002, chiefly because Fed Chairman Alan Greenspan remains a key proponent of that view. Moreover, in the policymaking Federal Open Market Committee's annual rotation of Fed district presidents, two presidents who openly opposed aggressive rate-cutting this past summer will rotate off the committee.

Rotating onto the FOMC will be Dallas Fed President Robert D. McTeer Jr., perhaps the strongest advocate of the productivity revolution. One of the less enthusiastic proponents of the strong-productivity story, former Fed Governor Laurence H. Meyer, chose not to seek reappointment. Plus, the board will include two brand new governors, who typically don't make waves and are likely to vote with the chairman. On balance, the 2002 policy committee appears to be a tad more dovish than the 2001 version.

Indeed, inflation hawks will have little to squawk about this year. Not only will productivity keep down labor costs, but price pressures from other sources will be almost nil. The considerable slack in production capacity, the steadfast strength of the dollar, and a global recovery that will be slow to develop mean that inflation simply can't get started.

Investors obviously have a huge stake in the belief that strong productivity gains will keep inflation down, lift investment and profits, and allow the Fed to keep interest rates low. That forecast is clearly built into current stock-market valuations. If that belief is wrong, it will become apparent as the recovery develops. More likely, the party will start slowly, and the Fed will keep the punchbowl generously filled.

By James C. Cooper & Kathleen Madigan

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