On Nov. 6, the Federal Open Market Committee lowered the key federal funds rate by 50 basis points to 1.25 percent in response to what Chairman Alan Greenspan subsequently termed “a soft patch” in the economy. After a strong third quarter, economic growth was clearly slowing markedly in the fourth, continuing the erratic and relatively weak pattern of expansion throughout this past year. The FOMC also stated in its announcement that the risks were now balanced with respect to its twin goals of price stability and sustainable economic growth for the foreseeable future.
The combination of a 50-basis-point reduction in the funds rate and a statement that the risks were balanced between sustainable growth and price stability is an oddity. If the risks were balanced, why in heaven’s name should the Fed have reduced interest rates at all? I suspect the reason for the statement was to bolster confidence in markets. The Fed didn’t want participants in markets to interpret a 50-basis-point move as an indication that the economy was falling apart. Judging by the reaction of financial markets since then, Fed policy makers succeeded in that endeavor.
Does the shift in the assessment of risks to neutral tell us anything about what the Fed will do on Dec. 10?
Not necessarily, for two reasons.
First, the FOMC never commits itself at any meeting beyond the decision made at that particular time. Second, the statement that the risks are balanced “for the foreseeable future” has minimal content in terms of its implications for future policy moves because the period in question is too vague. As Governor Susan Schmidt Bies stated in a recent speech, the foreseeable future ” … is not intended to refer to a specific time horizon, and indeed, when the FOMC introduced the balance of risks statement, it suggested that the time horizon encompassed by the foreseeable future might well vary depending on the economic circumstances.”
A better idea about what the Fed will do at its next meeting is obtained by following the advice of former Governor Laurence H. Meyer. When speaking publicly about monetary policy, he would respond to questions about the Fed’s next policy move by saying: “It depends.” It depends, he would state, on the data that come in between now and then. And most of the data that have come in since the November FOMC meeting suggest that the economy is emerging from the soft patch that motivated the easing at that time.
Housing activity continues to be strong. Existing home sales rose in October, and new home sales remained above 1 million at an annual rate. Refinancings are continuing at a record pace, enabling homeowners to cash out large amounts of equity — a substantial part of which will be spent on home improvements or on consumer goods and services. Auto sales rose in November, and consumer confidence rebounded smartly last month. Orders for durable goods increased in October, and the Institute for Supply Management’s composite indexes for both manufacturing and nonmanufacturing were up in November.
By far the most important data, however, have come from the equity markets. Stock prices have staged a spirited revival. The rebound has been broad-based, and has lifted the broadest index of stock prices — the Wilshire 5000 — by roughly 20 percent since the trough in October, increasing the equity net worth of American consumers by close to $2 trillion. That means stronger consumer spending going forward. More fundamentally, it indicates that risk premia are diminishing because a majority of equity investors perceive the American economy to be sound enough to continue on the road to sustainable economic growth. That more optimistic mood has yet to pervade corporate board rooms, where decisions about capital spending, a crucial element of economic growth, are made. But if recent gains in the stock market hold, and equity prices continue to move up, it will only be a matter of time before capital expenditures begins to play the invigorating role it has displayed in the past during periods of economic expansion.
These recent, more upbeat, economic data do not imply stronger growth in the current quarter. The November employment report clearly indicates that the economy was floundering in the fourth quarter. Real GDP will probably increase by only around 1 percent at an annual rate in this quarter — as any strengthening of consumer spending during the holiday season will probably lead to a reduction in inventories instead of an increase in production. But that will lay the basis for a pickup in industrial activity early next year, setting the stage for a return of economic growth to the economy’s long-term potential — which I estimate at about 3.25 percent per year — by the second half of 2003.
The outcome of the FOMC meeting on Dec. 10 is a no-brainer. Short-term interest rates will be left unchanged, and the announcement will indicate that the risks are balanced between sustainable growth and price stability. And this time the Fed may mean it!
Lyle E. Gramley is the senior economic adviser of the Schwab Washington Research Group. He spent the bulk of his professional career with the Federal Reserve, and was a governor of the Federal Reserve Board from 1980 to 1985.
— Posted: Dec. 9, 2002