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Commentary
Sustainable Accommodation?
In his July 20, semi-annual Congressional testimony, Federal Reserve Chairman Greenspan characterized the U.S. economy as being in a “sustained” expansion, which would cause the Fed to continue its measured pace of rate increases. And as expected, this week the Fed announced the tenth consecutive increase in the funds rate, to 3.50%. Once again, current policy was deemed to be “accommodative.” Subtle language was added, alluding to consumer spending: “Aggregate spending, despite higher energy prices, appears to have strengthened since last winter.”
When might “accommodative” give way to “neutral?” Let’s take a look at where we might find a possible definition of a neutral monetary policy: the difference between the Fed funds rate and the Fed’s favorite indicator of inflation—the year-over-year U.S. Personal Consumption Expenditures Price Index. Often dubbed the “real” funds rate, the difference between these variables is depicted in Figure 1. Over the past 20 years, the average real funds rate was 2.49%. Moreover, during mid-cycle expansions, which occurred in the 1985 and 1995 timeframes, the real rate ranged between 3.50% and 5.00%—far higher than the current level of just over one percent.
Figure 1: Historical Fed Funds Rate, Year-over-Year Personal Consumption Expenditures Deflator
Source: Bureau of Economic Analysis, Bloomberg
In spite of the fact that the Fed remains the only major central bank in the world that is tightening monetary policy, it is cognizant that “real” short-term rates remain low, especially in light of the facts that: (1) the longer-end of the yield curve is reluctant to steepen; and (2) unlike the case of several years ago, deflationary concerns remain subdued.
During the July 20 session, Mr. Greenspan continued to paint a picture of “sustained economic growth and contained inflation pressures.” Still, a few points raised concern:
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The favored PCE Price Index measurement of inflation is now projected to be in the range of 2.25% for 2005 and 2.50% for next year. These levels are higher than the respective forecasts of 2.00% that were issued six months ago. |
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The Fed sees danger that low interest rates have spurred “speculative fervor” in certain housing markets. |
The Increasing Role of the Cash-out Refi
Although recent history would tell us that Fed policy remains accommodative (in spite of 10 straight rate increases since June 2004), further increases in long-term yields could give the Fed less incentive to continue its march. Why? The Fed is clearly concerned about housing inflation and its corresponding multiplier effect upon the overall economy. While higher long-term yields could cool today’s hot housing market, too much of an increase in rates could send the housing market and the general economy into an unacceptable downward spiral.
Try these statistics on for size. During the second quarter of 2005, Freddie Mac, in its Quarterly Finance Review, noted that 74% of the mortgages in its portfolio that were refinanced converted to new mortgages with balances that were at least 5% higher than the original mortgages. During the first quarter of 2005, that same ratio was 64%. Further, Freddie Mac estimated that during the second quarter, cash-out refinancing generated $59 billion in discretionary cash. This amount of incremental liquidity has acted as a counter-balance to the depressive effect of higher oil prices and a deteriorating relationship between consumer spending (+0.8% in June) and consumer income (+0.5% in June). Still, there’s good reason to believe that the cash-out phenomenon could beat a hasty retreat if the long end of the yield curve continues its upward trend of the past two weeks. To the degree long-term yields continue to rise, the Fed may be inclined to pause at some point—possibly at the December meeting.
Productivity Down, Unit Labor Costs Up
As we’ve noted in the past, the Fed is keeping a watchful eye on the relationship between productivity and unit labor costs. During the second quarter, employee productivity increased by 2.2%, the slowest rate in almost a year. While the rate of increase in unit labor costs (a key measure of inflationary pressures from compensation) during the quarter (+1.3%) slowed somewhat, over the past year, unit labor costs increased at the fastest rate in over five years. The labor market continues to improve, with 207,000 additional jobs created during the month of July. In the recent words of Mr. Greenspan: “Over most of the past several years, the behavior of unit labor costs has been quite subdued, but those costs have turned up of late.”
Market Expectations: Higher Short-Term Rates, Stronger GDP
Economic estimates and money market futures are pointing to continued increases in short-term rates. This month’s estimates of select economists' forecasts show significant changes from July, with a composite forecast for a year-end Fed funds rate of 4.13%, climbing to 4.46% by mid-2006. These forecasts are comparable to this month’s forward yield curve analysis, which shows an expected Fed funds rate of 4.44% one year from now.
The select economists' forecasts also show substantial upward revisions to third-quarter GDP. Estimated GDP for the quarter increased to 4.7%, from last month’s estimate of 3.4%. Why the increase? It’s due to strong manufacturing orders, especially in communications equipment, semiconductors, and durable goods. Inventory replenishment will be a major contributor in the third quarter. What could pull down GDP growth estimates in a hurry? Continued high oil prices in advance of the home heating season and diminishing contributions from cash-out refinancing.
Making Room for the 30-Year Bond
After a five-year hiatus, the U.S. Treasury announced that it will re-introduce the 30-year bond, or “long bond” in early 2006. Auctions will be held semi-annually and sales are anticipated to be in the range of $30 billion per year. Currently, the Treasury conducts four refundings per year, consisting of three, five, and 10-year notes, along with its regular sales of bills and two-year notes. Relative to last year’s $724 billion in sales, $30 billion would represent less than 5% of total note auctions. Still, in the coming weeks, we’ll await word on which Treasury maturities will be proportionately reduced in order to make room for the long bond.
John Biestman is assistant vice president, IMS consultative
sales advisor at the Federal Home Loan Bank of Seattle.
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