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Will the Fed Tightening Cycle End in Early 2006?

 
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arthur
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PostPosted: Sun Dec 25, 2005 2:24 pm    Post subject: Will the Fed Tightening Cycle End in Early 2006? Reply with quote

U.S. ECONOMIC BACKGROUND AND POLICY

In a free market system, when demand exceeds supply, prices rise and there is excess profit. So, new supply is created, until excess profit disappears. In the U.S. over the past few years, inflation accelerated, corporations had strong profit growth, and the economy expanded at above trend growth.

Measures of inflation, e.g. the GDP Price Deflator, CPI, and PPI, show inflation has accelerated over the past few years. The Federal Reserve (or Fed) uses several measures of inflation. However, it's primary benchmark is the Personal Consumption Expenditures Chain Price Index, which is a component of the GDP Chain Price Deflator. U.S. inflation has generally risen from 1.5% in 2002 to 3.5% in 2005.

The S&P 500 had a record 14 consecutive quarters of double-digit earnings gains recently, and double-digit earnings growth is expected to continue into next year. Total U.S. corporate profits rose from 7% of GDP in 2001 to 11% of GDP in 2005. Consequently, the S&P 500 P/E fell from 45 in early 2002, which was an all-time high, to 18 in 2005.

Over the past 10 quarters, U.S. real GDP growth has averaged just over 4%, which is above the long-run trend rate of 2.8%. Real GDP growth for the most recent quarter was 4.1% (annual rate). Many forecasted that real GDP growth would slow to just over 3% in 2005, and may current forecasts are predicting just over 3% real growth in 2006.

The goal of the Fed is to preempt inflation, or deflation, to maintain price stability, because stable prices lead to stable output and employment. Sustainable growth, where there's neither strain nor slack in the economy, is optimal growth, which raises living standards at the fastest possible rate. Price stability tends to smooth-out the business cycle.

There are hundreds of major forces pushing and pulling a dynamic economy, e.g. the U.S., and the Fed must find the net effects of these forces, through their interrelationships and interactions. Moreover, the Fed must work in the future economy, because of lags in policy changes, using its several "crude" tools to control the economy.

The U.S. had 20 years of disinflation, from the early 1980s to the early 2000s. In 2002, the FOMC (policy-setting committee of the Fed) lowered the Fed Funds Rate to below 2%, and in 2003, lowered it to 1%. Over the past 18 months, the FOMC has raised the Fed Funds Rate 25 basis points at each meeting to 4.25%. Currently, financial markets are expecting the tightening cycle to end in early 2006, when the Fed Funds Rate reaches 4.5% to 5.0%.

Although, the FOMC has tightened the money supply, raising the Fed Funds Rate from 1% to 4.25% over the past 18 months, monetary policy remains accommodative. However, recently, the FOMC stated monetary policy is near neutral, i.e. a stance that neither stimulates nor slows the economy, and implied a "restrictive stance," of further tightening, to slow the economy to a sustainable rate.

POWERFUL FORCES INFLUENCING THE U.S. ECONOMY

"Information Age" firms accumulated economic inputs, e.g. labor, capital, raw materials, energy, etc., throughout the 1980s and 1990s, and became increasingly wasteful utilizing those inputs. Eventually, financial markets withdrew massive amounts of investment from those firms in 2000 to 2002 causing a quick and massive "Creative Destruction" process in the "Information Revolution." Consequently, Information Age firms became more efficient, producing more with less, and surviving firms became more price competitive, while improving their financial conditions.

Therefore, massive amounts of resources were "freed-up," in 2000 to 2002, and shifted into emerging industries. These inputs continue to flow into emerging firms, while older industries in the Agricultural-Industrial-Information Revolutions continue to become more productive. Consequently, the U.S. economy has become more diversified, which stabilizes the economy and helps smooth-out the business cycle. Moreover, the economic flexibility of the U.S. helps create the most advanced technologies and contributes to higher aggregate living standards, although income inequality remains high.

Labor economists refer to the 35-54 age group as "prime-age" workers, because it's the most productive group, based on education, experience, and training. The second most productive group is the 55-64 age group. The 80 million U.S. "Baby Boomers," born between 1946-64, are at their productive peaks. However, the Baby Boom generation hasn't saved enough to retire, and many lost much of their wealth when the Nasdaq bubble burst in 2000, which postponed many plans for early retirements (the stock market crash was a "correcting mechanism" to keep future labor supply and demand in equilibrium). Recently, many Baby-Boomers took advantage of the housing boom, including refinancing at lower rates to spend much of their housing gains to raise their living standards. Consequently, the Baby Boomers will have to work harder and longer before retirement, to maintain autonomous consumption.

The massive Creative Destruction process and the low saving rate of Baby Boomers are two powerful forces that have increased productivity and will maintain high levels of productivity over the next several years. Consequently, inflation may remain contained longer than expected. However, there are several other significant forces that will influence inflation, including monetary & fiscal policies, the "output gap," capacity utilization, the unemployment rate (Phillips Curve, i.e. inverse relationship between unemployment and inflation, and NAIRU, i.e. the Non Accelerating Inflation Rate of Unemployment estimated to be 5%), wage growth, commodity prices, the U.S. dollar, the balance of payments, and the yield curve.

Much of the slack, created by the massive Creative-Destruction process of the early 2000s, has been taken out of the economy, although monetary policy remains stimulative and fiscal policy is expansionary. Consequently, the output gap, i.e. the difference between potential and actual output, has closed, capacity utilization has increased, the economy is near full employment, wage growth is slow (although income growth is stronger), high commodity prices reflect economic strain in foreign economies, particuarly in Asia, a weaker U.S. dollar has spurred export growth, although import growth has been stronger, to keep the balance of payments balanced, and the flattening yield curve indicates economic growth will slow.

CONCLUSION

The Fed typically "overshoots" preempting inflation, because once inflation is out of control, massive amounts of liquidity must be drained out of the commercial banking system, which often eventually results in a recession. So, the Fed will overtighten rather than risk falling too far behind the inflation curve. Consequently, the Fed may continue to tighten beyond a neutral stance, and adopt a restrictive stance for some time. However, the Fed may pause in early 2006, when the Fed Funds Rate reaches 5%, after tightening 400 basis points over 16 consecutive FOMC meetings, since its campaign of "jawboning," to keep inflation expectations low, along with actual tightening have been effective. Nevertheless, future economic data will decide if or when the tightening cycle will continue.
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