Fed Pause Now Seen Later Rather Than Sooner
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Introduction

This week's letter is from another one of the country's top economic analysts, Paul Kasriel of The Northern Trust Company. Kasriel is Senior Vice President and Director of Economic Research, responsible for producing the Corporation's economic and interest rate forecasts. He advises the Bank's Assets-Liabilities Committee as well as the Corporation's Investment Policy Committee.

I am a big fan of Kasriel, and look forward to reading his outlook, as it always gives me an insight or two. His forecast at the beginning of the year was for the Fed to "pause" raising rates in early 2005, but now Paul is forecasting that the "pause" will come later in the year. While I am still of the opinion that the Fed will go further than any of us thought when they started to raise rates last year, Paul gives us another well-reasoned viewpoint in this week's Outside the Box. Statistics and charts are presented to help back up his case.

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Fed Pause Now Seen Later Rather Than Sooner

February 14, 2005
by Paul L. Kasriel 

We have not abandoned our Fed "pause" theme, but have changed the timing of it. Rather than the Fed pausing in its measured pace of interest rate hikes in the first half of 2005, we now see that pause coming in the second half. Because we now believe that Fed interest rate increases in 2005 will be frontloaded, we have reduced our 2005 real GDP forecast modestly as well as our inflation forecast.

We continue to believe that U.S. economic growth is in the process of slowing. Why? For starters, despite massive amounts of fiscal and monetary policy stimulus, the best that the economy could do was grow at a compound annual growth rate of 3.46% in the 12 quarters of recovery/expansion. As the table below shows, economic growth in this expansion underperformed the average growth in previous post-war expansions by 140 basis points. Although growth in the current expansion outperformed growth in the previous expansion by 40 basis points, there was not nearly the policy stimulus expended during that one. In fact, tax rates were actually raised and federal spending growth was slowed. The point of all this is that with monetary stimulus being reversed and no additional fiscal stimulus on the near-term horizon, it is difficult to make a case for stronger economic growth going forward.

 
Chart

The behavior of the Leading Economic Indicators index (LEI) is telling us that an economic slowdown is in the works. Chart 1 shows that the year-over-year growth in the LEI has slowed from about 4% in mid 2004 to less than 1% at the end of 2004.

 
Chart 1
Chart 1

We believe that some components of the LEI have more "information" about the future course of economic growth than others. The two components we place the most faith in are the real M2 money supply and the spread between the yield on the Treasury 10-year security and the fed funds rate. Charts 2 and 3 show the historical relationship between our two favorite "leaders" and domestic demand.

 
Chart 2
Chart 2


 
Chart 3
Chart 3

Recent behavior of real M2 growth and the yield spread point to softer economic growth ahead. Chart 4 shows that although the monthly year-over-year growth in the real M2 money supply has picked up a bit in the past two months, at 3.2% it is only at approximately the growth rate that preceded the 2001 recession. Chart 5 shows the recent behavior of the yield spread. It has gone from about 390 basis points in mid June of 2004, just before the Fed began raising the funds rate, to about 150 basis points of late. That is a rapid narrowing in this spread. With the Fed expected to keep pushing up the funds rate through the first half of this year, we would expect nominal M2 growth to be pushed lower and for the yield spread to narrow further.

 
Chart 4
Chart 4


 
Chart 5
Chart 5

The narrowing in the yield spread has occurred not only because of a rise in the fed funds rate, but also because of an outright decline in the Treasury 10-year yield. This yield recently peaked at 4.89% on June 14, 2004, trading down to 4.00% on Wednesday, February 9, 2005 - a decline of 89 basis points. It is not unusual for the 10-year - fed funds spread to narrow as the Fed begins to lift the funds rate. It is, however, unusual for this spread to narrow with the yield on the Treasury 10-year actually falling this early in a Fed tightening cycle. Why has the yield on the Treasury 10-year been falling? One explanation is that bond investors have faith in the Fed to keep a lid on inflation. That is, as the Fed has begun to raise the funds rate, bond investors have lowered the premium they demand to compensate them for the risk of higher future inflation. One way to measure this faith in the Fed as the keeper of price stability is to observe another interest rate spread. That spread is the one between the yield on a Treasury security that provides no insurance on inflation-adjusted returns versus the yield on a Treasury security that does provide some inflation insurance - Treasury Inflation-Protected securities (TIPS). The spread between these two yields is a proxy for bond investors' expectations about future inflation. Chart 6 shows that the market's expectations of the future 10-year CPI inflation rate fell from inflation expectations' spread has narrowed from 2.63% on June 14, 2005 to 2.51% on February 9, 2005 . So, a decline in inflation expectations accounts for only 12 basis points of the 89 basis point decline in the nominal yield on the Treasury 10-year security between mid June of last year and early February of this year.

 
Chart 6
Chart 6

By definition then, the remaining 77 basis points of the decline in the nominal 10-year yield had to come from a decline in the real component of the nominal yield. This is shown in Chart 7. The 10-year TIPS yield, or real yield, fell from 2.26% on June 14, 2004 to 1.49% on February 9, 2005 - a decline of 77 basis points.

 
Chart 7
Chart 7

One can easily rationalize why the inflation expectations component of the bond yield might fall when the Fed was raising the real fed funds rate. All else the same, a rising real fed funds rate implies that the Fed is slowing the growth in the supply of "counterfeit" credit it is providing to the economy, which should limit future inflation. But why would the real bond yield fall when the Fed is raising the real funds rate? Our hypothesis today is the same one we mentioned back on October 8, 2004. Namely, we think that the decline in the real bond yield may be related to a decline in the expected real return on capital in the U.S. This is consistent with the atypical financial surplus that Corporate America currently is running. That is, corporations' cash flows exceed their expenditures on capital equipment, structures and inventories despite the fact that their cost of capital is relatively low. Rather than splurging on capital spending, corporations are retiring equity and buying other existing corporations. This behavior is consistent with an expected low return on capital. A low and declining expected real return on capital is not indicative of a strong economy. A rising real fed funds rate in the face of a falling real bond yield would suggest to us that monetary policy is no longer accommodative, but is getting restrictive. (As an aside, the expected real government bond yield implicit in President Bush's proposal for personal Social Security accounts is 3%, which presumably was arrived at by looking at some long-term average. On February 9, the real government bond yield was only 1.49%!)

 
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Another explanation that is implicitly being offered for the recent decline in real bond yields is that pension funds have developed a penchant for bonds over equities. This reminds us of a popular explanation for the inversion of the 10-year Treasury - fed funds spread back in 2000. That explanation had to do with the Treasury's decision to cease and desist in the further issuance of 30-year bonds. The lack of supply of longer duration bonds allegedly was driving down 10-year yields. It turned out that the sharp decline in the 10-year Treasury yield in 2000 was a harbinger of the recession of 2001. Once burned, twice warned? Don't get us wrong. We are not suggesting that the recent decline in the yield on the Treasury 10-year is a sign of an impending recession, just a slowdown.

Where will this slowdown manifest itself? We believe the leading candidates are consumer spending and housing. Let's start with consumer spending. Chart 8 shows that the growth in real after-tax household income, adjusted for Microsoft's special $32 billion dividend payment in December of last year, slowed from 3.9% in the fourth quarter of 2003 to about 2.7% in the fourth quarter of 2004. This slowing in after-tax income growth occurred despite a pickup in employment growth in 2004. There were two principal reasons for the slowdown in real after-tax income growth. Firstly, the initial stimulus of the 2003 personal tax-rate cut waned. Although tax rates were not raised, they were not cut again. Thus, actual tax payments started rising in 2004, biasing down after-tax income growth. Secondly, consumer inflation picked up in 2004, thereby biasing down real after-tax income growth. Because we are forecasting slower real GDP growth this year versus last (3.2% versus 3.7%), we do not expect more robust employment growth. This will limit growth in before-tax labor income. And we do not expect that personal tax rates will be cut this year. So, after-tax income will again be biased down. Slower inflation (2.6% versus 3.4%) will provide some upward bias to real income growth. The combination of relatively slow real after-tax income growth, rising real short-term interest rates, and slower growth in household net worth owing to an expected slowing in house-price appreciation is likely to slow the growth in consumer spending.

 
Chart 8
Chart 8

Growth in residential construction already has slowed, as shown in Chart 9. We expect it to slow more in 2005. On the demand side, housing affordability has begun to decline, in part, because the value of residential real estate relative to after-tax household income has risen to a record high (see Chart 10). Housing affordability also will be adversely affected in 2005 because of further increases in short-term interest rates. Why will rising short-term interest rates hurt housing demand? Because, as shown in Chart 11, there is a growing preference for adjustable rate mortgages relative to fixed-rate ones. We believe that one of the reasons for the increased popularity for adjustable rate mortgages is that because of the sharp run-up in house prices relative to income, the lower monthly payments associated with adjustable rate mortgages relative to fixed rate ones is the critical factor in qualifying some home buyers for mortgages. The rise in short-term interest rates will also limit cash-out mortgage refinancing activity, which, in turn, will be a negative for consumer spending.

 
Chart 9
Chart 9


 
Chart 10
Chart 10


 
Chart 11
Chart 11


Likely to adversely affect the supply side of the equation for housing is the supply itself. The inventory of unsold new houses is rising absolutely and relative to new home sales, as shown in Chart 12. The combination of rising supply and moderating demand is not a winner for the residential real estate sector in 2005.

 
Chart 12
Chart 12


One area where we do expect continued strength is the export sector. Although there was a slowdown in growth in the fourth quarter, for the year as a whole, there was a solid recovery in export demand in 2004 (see Chart 13). Because we are forecasting a continuation in the downward trend of the foreign exchange value of the dollar, we believe export growth will remain relatively strong in 2005.

 
Chart 13
Chart 13


 
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In our January commentary, we said that we were "clinging" to our forecast of a pause in Fed rate hikes following the February FOMC meeting. We have let go of this forecast. We still see a Fed pause, but we now think it is more likely to come in the second half of 2005 rather than the first half. Why? For starters, although real GDP growth in the fourth quarter of last year was a relatively modest 3.1%, private domestic demand growth was anything but modest at an annualized rate of 5.5%. Moreover, GDP growth is likely to be revised higher. Although we are forecasting soft sequential monthly growth in real consumer spending in the first quarter of this year, the arithmetic of quarterly averaging should give us annualized consumption growth of about 3-1/4% -- solid enough to yield real GDP growth of about 3-1/2%. Last month, we were forecasting only 3% real GDP growth for the first quarter. Although there is not a huge difference between 3% and 3-1/2% annualized growth in terms of quarterly data, we think there is enough difference to keep the Fed on its "measured" pace of rate hikes through the March 22 and May 3 FOMC meetings. Also, for all its forward-looking rhetoric, we have observed that the Fed tends to base policy on the here-and-now rather than trust any of its forecasts. And the here-and-now is strong enough to induce the Fed keep raising rates. The Fed embraces the labor theory of value. That is, it believes that inflation grows out of higher labor costs. And unit labor costs have started to rise again, as shown in Chart 14 - another reason for the Fed to stay on the measured tightening course. Finally, over the past 40 years, the average spread of the fed funds rate over the core CPI inflation rate has been about 200 basis points. With the core CPI up 2.1% on a Q4/Q4 basis in 2004, the fed funds rate ought to be around 4% based on the historical average. 4% is far cry from the current 2.5% level of the fed funds rate. So, the Fed probably feels that it has "miles to go before it sleeps." We are not so sure the Fed has a far to go as it thinks, but that is because we tend to look at leading indicators. It doesn't matter what we think, however, when it comes to near-term forecasts of the fed funds rate. It matters what the Fed thinks. But if the leading indicators are sending a true signal, then another 75 basis points worth of Fed rate hikes in the first half of this year should weaken economic growth enough to cause a pause in Fed rate hikes for the second half.

 
Chart 14
Chart 14


Paul L. Kasriel, Director of Economic Research and Asha G. Bangalore, Economist

Conclusion

I hope you enjoyed Paul Kasriel's commentary. You can find the original and past commentaries at http://www.ntrs.com/library/econ_research/outlook/index.html.

Your keeping an eye on the Fed analyst,


John F. Mauldin
johnmauldin@investorsinsight.com

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Posted 02-21-2005 3:35 AM by John Mauldin