April 29, 2005

 

 

Editor

Donald R. Byrne, Ph.D.

 

Associate Editor

Edward T. Derbin, MA, MBA

 

 

 

Note: To print a hard copy of this newsletter, click on the following link for a PDF download…

Newsletter Volume 2005 Issue 1 Complete.pdf

 

 

 

FEDERAL RESERVE AND INTEREST RATES: CONUNDRUM, CONSTERNATION, OR CONFUSION 

 

The Recession of 2001, yet again…
There is a widely held belief that the economy began to slow down and entered into a recession in the second quarter of 2001.  The NBER (National Bureau of Economic Research http://www.nber.org/cycles/recessions.html), an economic organization has asserted as much.  Looking at the following schedule and accompanying graph, you might find a different interpretation.  It is our contention that the slowdown actually occurred in first quarter of 2000 after a fourth quarter of 1999 sizzling real growth of 7.3% annualized; the economy destabilized and the result was a plunge in GDP…

 

 

 

 

 

 

 

NBER: “According to the chronology, the most recent peak occurred in March 2001, ending a record-long expansion that began in 1991. The most recent trough occurred in November 2001, inaugurating an expansion.”

 

By historical definition, since we did not have at least two consecutive quarters of real negative growth, we did not have a recession.  The infamous second quarter of 2001 was positive in the first estimation, later revised downward and finally, the last revision for that quarter was positive yet again.  Again, the rules, according to the NBER have been changed: from as much as we can tell, a recession is based on a vote; a board reviews whether or not they deem a recession has in fact occurred. 

 

The year 1999 ended with a fourth quarter real positive growth of 7.3%.  That growth rate had fallen to a negative growth rate of 0.5% by the third quarter of 2000.  If a recession was to be designated, the beginning of it should have been dated as the first quarter of 2000 and surely no later the second or third quarter of 2000.  To say it began in 2001 first quarter makes all such future designations highly subjective and suspect.

 

Fiscal Factor – Taxes

 

 

 

 

 

 

The year 2000 marked the 8th consecutive year of rising tax revenues, partly caused by periodic tax rate increases.  By 1999, $111 billion surplus in the Federal government’s general account occurred as well as a rising surplus in the Social Security budget.  The U.S. Trade Deficit had reached a very high level of $260 billion by 1999.  Despite the self-kudos by Federal officials pointing to the “achievement” of a budget surplus beginning in 1998, one has to remember that budgetary deficits still stimulate economic activity, while surpluses actually depress, regardless of the political merit or popularity. 

 

 

 

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Yes!  Budgetary surpluses still depress the level of economic activity. 

 

Taxes by government reduces the disposable income of productive resources like labor.  They receive their income by supplying productive resources in the process of producing goods and services.  When some of that income is taken from them in the form of taxes, they can no longer buy all of the goods and services they have produced.  This reduces Aggregate Demand.

 

Government spending stimulates in one of two ways: if government spending is on services (education, transportation, defense, etc.) it adds directly to aggregate demand.  Much of the government’s spending is on transfer payments (Medicaid, Medicare, Family Income Allowances, etc.).  As recipients makes choices in this area, it adds to aggregate demand.  For approximately two years, while the federal government was running a surplus, taxes – which depress, exceeded both types of government spending: hence, the government surplus reduced aggregate demand, thereby depressing the economy.  It should also be noted that when the federal budget deficit shrinks, as it did for several years, that it reduces the stimulating affect of that deficit: hence adding to the depressing affect of the growing trade deficit.  

 

…and Trade deficits still depress the level of economic activity.  This occurs when U.S. imports of goods and services exceeds U.S. exports of goods and services.  U.S. imports depress economic activity by using income received for producing goods and services in the U.S. and taking some of that income to buy foreign goods and services and not our own – this depresses aggregate demand.  When foreigners buy our exports of goods and services, this adds to the aggregate demand of the U.S. without adding to the total supply of our goods.  The foreign resources earn their income by producing goods and services in their countries.  When they import our goods and services (U.S. exports), they refrain from exclusively buying their own domestically produced goods and services; instead, they buy some of our goods and services – adding to our aggregate demand.  Thus, when we import more than we export, it depresses the U.S. economy (refer to our newsletter on trade deficits   

http://www.udmercy.edu/faculty/byrned/2003%20Volume,%20Issue%203/balofpayart.htm).

 

 

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Here comes the Fed…

 

 

 

 

The Fed t to the Rescue... From the first quarter of 1999 to the second quarter of 2000, the Fed influenced the Fed Funds rate up by 175 basis points. While the economy was already in rough shape, dropping from over 7% growth in the fourth quarter of 1999 to negative territory by the third quarter of 2000, the Fed's actions only caused to further destabilize the economy.

 

 

By 2000, the U.S. was experiencing a lethal combination of a large Federal Government budget surplus, a growing Social Security System surplus and a huge trade deficit.  This was a time bomb waiting to explode.  While this combination was sufficient in itself to bring down a rapidly growing economy, 7.3% real annualized growth in the fourth quarter of 1999, the Fed, appearing blissfully ignorant of these conditions, was the spark to blow apart the rapidly growing economy.  Paranoid about the possibility of a return to significant inflation, it began a period of restrictive monetary policy by influencing interest rates upward.  The collapse began in the first quarter of 2000, rebounded slightly in the second quarter of that year, but then turned negative by quarter three of 2000. 

 

The record is absolutely clear…

 

Perhaps the Fed was a victim of its past where preoccupation with fighting unemployment led them to ignore the persistent rise of the inflation rate and its explosive acceleration in the late 1970s as it approached 20% at an annualized rate.

 

That was nearly 20 years before the fiasco of ill-advised monetary and fiscal policies leading to the collapse of 2000.  The inflation of the late 1970s was real.  There was no such evidence of inflation in 1999. 

 

Beginning in 2004, the Fed once again began to force short-term interest rates upward.  From about a 1% overnight Fed funds rate to about 2.75% April of 2005. 

 

 

From June 2004 to April 6, 2005, the Federal Funds Rate was influenced upward by 178 basis points (from 1.03% to 2.81%). In that same period, the 10-yr US Government Constant Maturity's yield dropped by 33 basis points (from 4.73% to 4.4%). If inflation were truly a concern, it would be reflected in the long-term rates - according to the marketplace where the 10-yr security is traded, this has clearly not been the case.

 

 

Focusing more narrowly on the Fed’s actions

 

First, some background…

The Expectations Theory of the Term Structure of Interest Rates, widely held by analysts, argues that the relationship of interest rates of varying maturities (the graph of which is the yield curve) is determined by the markets expectations of short-term rates over the coming relative period.  For example, the 10-year rate is the geometric average of the expected short-term rates over the coming ten years. 

 

Since the Fed operates primarily in the short-term end of the market by buying and selling short-term securities, it is not certain of the impact of these open market operations on the longer term rates.  Their apparent frustrations (a.k.a. conundrum) appears to be the decline of longer term rates (e.g., 10-year government bond rates) even though they have forced up short-term Federal funds rates by 150 basis points.  What this means is that the market has formed expectations of the coming ten years of short-term rates to cause the longer term rates to be lower than the Fed wanted them to be…

 

In one sense, the market could be convinced that the Fed’s current policy will cause either an elimination of inflation, or perhaps, the beginning of deflation, or even a recession in the ensuing years.  In the other sense, that means longer term rates will have smaller inflation premiums embedded in them or that a weakened economy will result in lower real interest rates. 

 

The market is of the belief that short-term interest rates are going to rise less in the future than the Fed believes.  Recall that in the Expectations Theory, actual long-term rates are the geometric average of the expected short-term rates for that time period. 

 

It is clear that the Fed does not control expectations of future short-term interest rates.  Some possibilities are that the Fed has set off fears of a softening economy, or that the public believes that any remaining inflation will be eliminated, if not outright deflation occurring.  An alternative to the Fed’s fear of inflation could be that they want short-term rates higher in order to give them some room to maneuver should the economy actually soften (providing them an opportunity to lower interest rates should the need arise). 

 

 

The New Economic Paradigm

Its Increasing Relevance and answer to Greenspan’s Conundrum

 

There are a couple of problems in the Fed’s monetary policy, both in 1998 – 2000 and currently in 2004 – 2005.  What the Fed fails to understand is that in an environment of significant competition, demand-pull inflation is much less likely to occur than in the past.  What the Fed seems to be unable to fathom is that inflationary pressures occurring today are coming primarily from the oil industry, or a cost-push variety of inflationary pressure.  The Fed has never successfully tamed cost-push inflation (witness the two oil shocks in the 1970s) without a dramatic decline in the economy and large collateral effects – as seen in the engineered collapse of the economy in 1980 – 1982.  What the Fed needs is to humbly admit that the cost–push inflationary pressures we are now experiencing, while increasingly dampened at the retail level, can be best addressed by the Anti-Trust Division of the Justice Department.  In the meantime, sub-par profits are accelerating structural unemployment. 

 

 

As another indicator of those evolutionary, but dramatic changes in the increasingly competitive U.S. markets, note the changes that have also been occurring on the international front. Increasing competition in the world, as well as domestically in the U.S. has brought together the behavior of commodity prices facing both the developing and advanced countries... In short, we now have essentially one world price for commodities and those prices are remaining fairly low.

 

As another indicator of those evolutionary, but dramatic changes in the increasingly competitive U.S. markets, note the changes that have also been occurring on the international front.  Increasing competition in the world, as well as domestically in the U.S. has brought together the behavior of commodity prices facing both the developing and advanced countries. 

 

 

For the past five years, as contrasted with previous data, the Consumer Price Index CPI no longer reflects the Producer Price Index pressures.  The CPI has been rising less than the PPI in three of the last five years.  Remember also, that the CPI includes services at the retail level have in previous years, been the main source of inflation.  Even with these included, the CPI is reflecting less inflation than the PPI.  This is in stark contrast to what has typically been the case in the past. 

 

 

Growing Relevance (Evidence) of the New Paradigm From 1979 - 1999, the CPI rose higher than the PPI in 20 of 21 years. In the five years, from 2000 - 2004, the CPI was higher than the PPI twice. From 1979 - 1999, the PPI has averaged 3.2% inflation and the CPI averaged 4.6%. In that time, a whopping 45.0% incremental inflation was passed through the CPI from producers to consumers. Since 2000, there's been a sea change in the economy -------------------------------------------------------------------------------------- --- VERY LITTLE PASS THROUGH ON PRICES FROM PPI TO CPI--- -------------------------------------------------------------------------------------- The PPI averaged 2.2% inflation over that time and CPI has averaged 2.5%. Only 13.4% incremental inflation has passed through from the PPI to the CPI.

 

 

Another one of Greenspan’s so-called conundrums, or areas of concern is productivity.  The data increasingly shows more rapid rates of growth in productivity, especially in areas where competition has been forcing restructuring.  The restructuring, whether through outsourcing, automation, etc., results in higher output per worker.  The increases in productivity offset increases in compensation – as a result, the figures on unit labor cost have been trending down for the past five years.  In this newsletter, we have pointed out several instances showing that “The New Paradigm” is in fact evolving through increasing competition and in an ever-widening pattern of markets.  While there has been a major increase in oil costs as seen in oil prices and in imported oil price statistics, much of the cost pressures – including oil prices, have been substantially muted at the consumer price level because of the inability to pass those costs on in the form of higher prices.  This is all consistent with the increasingly growing and diffused pressure of competition. 

 

 

There is sea change in the area of productivity as well... Productivity in the U.S. has risen from 0.5% in 1995, to 4.0% in 2004. Unit labor cost dropped from 4.2% in 2000 to 0.4% in 2004. Gains in compensation have been offset on the cost side through increased productivity.

 

 

 

 

It must be stressed that the rise in import prices, dominated by oil, underscores the argument that this is not generalized inflation, but rather coming primarily from one source – energy.

 

Again, most of the current inflationary pressures are coming from the energy sector.  The price of imported oil has risen by 36% from April 2004 to March 2005.  

 

 

Overall import prices increased by 7.1% from April of 2004 to March 2005, while energy increased by 36.1%. Without oil, imports prices increased only 2.9%.

 

 

 

Bear in mind that we consume around 20 million barrels of oil per day and of that amount, we import well over half…but we’ll speak to that in the next issue.    

 

 

Finally…

The Fed should realize that the traditional monetary policies used to combat demand-pull inflation cause extreme collateral damage to the economy, including a slow-down because inflation is coming from the aggregate supply side (cost-push) in the form an oil shock.

 

 

 

When, oh when, will the Fed understand this distinction?

 

 

 

 

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