he recent economic data clinched the case for the FOMC to start its tightening
campaign at the June 29- 30 FOMC meeting. Compared to past tightening episodes,
the game plan is clear because Fed officials have been forthcoming in their
thinking. Assuming no unusual data surprises, Fed officials plan to tighten
at a "measured" pace, with a series of 25-basis-point moves the most
likely outcome. As a result, uncertainty about the federal funds rate path pertains
much more to 2005 than the next six months. How far the FOMC will have to go
and how long it will take to get there remain uncertain. Our view remains that
Fed officials will take a break from the tightening process after, perhaps,
four 25- basis-point moves.
The notion is that the economy is likely to slow in response to tighter financial
market conditions and other factors, such as the ongoing shift in fiscal policy,
that restrain consumer spending. Such a break in the tightening process would
then cause financial conditions to ease and the economy to strengthen anew,
setting the stage for a revival of the tightening campaign during the second
half of 2005. In our forecast, the federal funds rate only rises to about 2.50%
by the end of 2005, but with further tightening likely in 2006. However, if
real GDP growth stays elevated and productivity growth falls sharply, then this
view would probably be wrong. Pressure on resources would build more quickly,
necessitating a less measured approach to tightening monetary policy.
Transparent and Measured
The conduct of monetary policy has changed significantly since the
1994-1995 tightening episode. Fed officials are now transparent in their intentions.
They expect the tightening process to be "measured." In contrast,
a decade ago, Fed officials were much more guarded in sharing their thought
process and unwilling to strongly foreshadow a particular path of monetary policy
tightening. The shift in Fed policy toward transparency presumably stems from
the growing dominance of the capital markets in the US financial system. The
share of credit market debt (including loans) held directly by depository institutions
has shrunk over the past few decades.
Similarly, the US equity market has also increased in its importance. Equities
have climbed to about 42% of household financial assets, up from 25% in 1980.
The proportion of households owning stocks and mutual funds has also increased
sharply. Finally, the valuation of the dollar has become more important as the
economy has become more open. The combined share of exports and imports relative
to GDP has climbed to 24.4% from 9.5% in 1960. As a result, monetary policy
has come to be transmitted mainly by shifts in financial market conditions-the
level of short- and long-term interest rates, the level of equity prices, and
the value of the dollar.
This means that it has become more important that the markets "get it
right" about Fed policymakers' intentions. Otherwise, the monetary policy
impulse will be subverted by movements in the components of financial market
conditions that are inconsistent with the FOMC's intended path for the federal
funds rate. In this regard, Fed officials have to be pleased about the recent
tightening of financial market conditions.
The FOMC's intention that monetary policy tightening will be "measured"
reflects five major considerations.
First, with financial conditions now tightening ahead of the rise in short-term
rates, shifts in monetary policy work faster, making it less important that
Fed officials act preemptively.
Second, the low level of inflation also means that there is no need for monetary
policy tightening to be preemptive. For example, if the FOMC's implicit target
for the core PCE deflator is a range of 1% to 2%, then the core PCE deflator
should be allowed to rise to the top end of this range (if not slightly beyond)
by the end of the economic expansion. The era of "opportunistic disinflation"
in which Fed officials kept inflation in check during expansions and reaped
disinflationary dividends during economic downturns has passed-at least temporarily-because
Fed officials have achieved their inflation objective.
Third, Fed officials plan to be "measured" because they believe that
the economy still has "appreciable" slack. As a result, most members
of the FOMC believe that the recent uptick in inflation-to quote Governor Kohn-"probably
does not represent the leading edge of steadily worsening inflation."
Fourth, there is considerable uncertainty about how the economy will respond
to the tightening of financial conditions provoked by monetary policy tightening.
This is an atypical expansion. There is little pent-up demand among households.
Instead, the household financial balance-the difference between household income
and spending-is unusually depressed right now. This balance stood at -2.2% of
GDP in the first quarter, about 4.4 percentage points below its long-run average.
Past post-bubble experiences suggest that the central bank should proceed cautiously.
In similar circumstances, premature tightening pushed the US economy back into
recession in 1937 and Japan back into recession in 2000.
Fifth, the 1994 experience presumably has made Fed officials more determined
to anchor market expectations about the likely magnitude of tightening.
Although the 1994-1995 tightening episode ended happily for the Fed with a
soft landing, it was not without its scary moments. In particular, market participants
priced in considerably more tightening than Fed officials ever contemplated.
This tightened financial market conditions and increased the risks of an inadvertent
hard landing. As shown in Exhibit 4, Eurodollar futures yields climbed to levels
more than 200 basis points higher than the 6% peak in the federal funds rate.
How Much Tightening in 2005?
The outlook for 2005 is very cloudy. It depends on the strength of
the economy, how much this tightens up the labor market, and the consequences
of this tightening for wage compensation and price inflation.