U.S.: No More Pedal to the Metal for the Fed

With growth accelerating, it will ease up on the gas--but when?

When and how much? Those are the questions on the lips of investors, bondholders, and other Federal Reserve watchers. The Fed kept interest rates on hold at its Mar. 19 meeting. But the accompanying statement, in which the Fed abandoned its view that economic weakness was the greatest risk in the outlook, makes it clear that policymakers are thinking about the timing of rate hikes in order to bring monetary policy back to a neutral stance.

Bear in mind that neutrality does not mean restrictive. The Fed's aim is not to cool off an overheating economy but to ensure that today's highly stimulative policy does not generate one in 2003. In the coming months, the Fed will begin to take its foot off the gas pedal, which is not the same as slamming on the brakes. Prior to September 11, the Fed was already discussing when preemptive tightening might be appropriate.

Right now, the current federal funds rate of 1.75% looks increasingly inappropriate, given the rapidly improving tone of economic data in recent months. Historically, monetary policy has been in a neutral stance when the real fed funds rate--the target rate minus inflation--stood at about 2.5% (chart). Anything above that rate is restrictive; a rate below is stimulative. By that definition, today's real rate of less than 1% is too low for an accelerating economy.

Such was the case in 1994, when the real funds rate was about 1%, and the economy was picking up. The Fed began a series of rate hikes totaling 3 percentage points. Don't expect that much tightening this time, because the Fed's two main concerns in 1994--rising capacity utilization and cost pressures--are absent now.

EVEN SO, TWO OTHER FACTORS argue for some rise in short-term rates--perhaps as early as June, as Wall Street now expects. First, the stronger tone of the recovery has lifted the yield on 10-year Treasury notes by more than 40 basis points in only the past three weeks. Policymakers don't want to fall too far behind the bond market.

Second, the Fed pumped out a massive amount of liquidity following September 11 in order to keep the financial markets on an even keel, which in hindsight may have been excessive. The funds rate dropped from 3.5% to 1.75%. That means a rise of 175 basis points over the course of 2002 would only put the funds rate back to its stimulative level of last August.

By the Fed's next meeting, on May 7, the Commerce Dept. will have released its first look at first-quarter real gross domestic product. The latest news on business inventories, industrial production, and foreign trade indicates real GDP is growing at an annual rate of about 4% in the first quarter. However, the top-line GDP number won't carry a lot of weight at the Fed. Instead, policymakers will focus on where growth came from. How much was due to an upturn in the inventory cycle? How much reflected increased overall demand?

The mix is important because it will determine the pace of the recovery later this year--and of policy decisions. Indeed, the Fed all but laid out the road map it will follow this year. The policymakers plainly stated on Mar. 19 that even though the economy is expanding "at a significant pace," growth is due largely to "a marked swing in inventory investment." The Fed's worry: If the economy grew by 4% in the first quarter with a slower pace of inventory drawdown accounting for 3 percentage points of that increase and domestic demand only 1 point, then demand is too slow and the recovery won't last into the second half.

But the Fed went on to emphasize that "the degree of strengthening in final demand in coming quarters, an essential element in sustained economic expansion, is still uncertain." So if first-quarter growth is more evenly divided, with prospects for a speed-up in demand in the second and third quarters, then the Fed may feel more urgency in moving policy toward neutral sooner rather than later. While the Fed's words lessen the chances of a rate hike at the May meeting, they do set the criteria for a possible hike at the June 25-26 meeting.

THE LATEST DATA seem to come down on the "evenly mixed" scenario. Businesses are backing off from last year's feverish pace of stock-cutting, but domestic demand is holding up. Factories are busier in response to rising orders. In particular, the makers of tech equipment are boosting output at a rapid clip (chart, page 27). At the same time, the wider trade gap in January suggests that some of the inventory swing is benefiting foreign producers. Keep in mind that a bigger trade gap subtracts from economic growth, but a rise in U.S. imports is necessary to engender a global rebound. That will eventually boost exports as well and help to better align monetary policy around the world.

The Fed's decision to shift to a neutral stance was probably made easier by the latest good news on industrial production. Output at factories, utilities, and mines increased 0.4% in February on top of a 0.2% January gain, which was first reported as a 0.1% loss. Manufacturing output rose 0.3% in each month, the best showing since mid-2000.

Surprisingly, the long-ailing tech sector is leading the charge. Tech production is growing at a double-digit annual rate in the first quarter, vs. almost no gain in the rest of manufacturing. But even that small rise in nontech manufacturing is a vast improvement from the steep declines of the previous six quarters.

SOME OF THAT INCREASED PRODUCTION is going into inventories. Stockpiles at manufacturers, wholesalers, and retailers edged up 0.2% in January, the first increase in a year. Business sales surged 1.1%, meaning that the ratio of business inventories to sales dropped to 1.37, the lowest in almost two years. Of course, computerized inventory tracking means businesses now keep fewer goods on hand than they did a decade ago. What's important for future production gains is that the January inventory-sales ratio stood below this long-term down trend (chart). As a result, orders and output will keep rising in coming months.

Foreign producers will reap some of the benefits from the upturn in U.S. demand and inventory rebuilding. Imports surged 3.6% in January, leading to a sharp widening in the trade deficit, to $28.5 billion from December's $24.7 billion. Exports slipped 0.1% in January, but as global demand gains momentum, foreign shipments will recover.

Just as tech is fueling the rebound in U.S. factory activity, tech imports are leading the import rise. Incoming shipments of tech goods jumped 14.6% in January, suggesting stronger capital spending.

As demand picks up, the Fed will want to remove itself from the equation of economic pluses and minuses. Step One was the shift in its view of the outlook. Step Two will be a series of rate hikes that will bring policy more in line with sustainable economic growth.

By James C. Cooper & Kathleen Madigan

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