Wednesday, June 07, 2006

What's your take on interest rates?

In a public appearance on Monday, Fed chairman Ben Bernanke highlighted the state of the economy and, according to the media, sent down the DJIA by 1.77%.

What did he say about the economy? And what's the relevance of his comments for future interest rate policy? I am going to review his comments and take a stand on the next target for the federal funds rate.

Bernanke aknowledged the robust (i.e. above trend) growth of the U.S. economy during the past three years and attibuted it mostly to advances in productivity and increase in the labor force ---underlying fundamentals. But then he stated:

" While we cannot ascertain the precise rate of resource utilization that the economy can sustain, we have little doubt that after three years of above trend growth, slack has been substantially reduced."

This is a statement that the economy, given current resources and technology, is approaching full production capacity. In my macro class, I call this region of the aggregate supply function the "danger zone", an area in which the Fed start to worry about inflation. This is because further increases in production, due to increased aggregate demand, can come only at higher prices.

Bernanke says there is little doubt about it, we are in the danger zone!

Increasing prices, inflation, tend to reduce excess demand, demand that is not sustainable in the short run because the economy is near full capacity. Bernanke is not sure that this is already happening, here is why.

He says that personal consumption expenditures, which make two thirds of US output, has shown slowing growth in the past quarter. High energy prices affected income and expenditure of an increasing number of households. Fuel prices have increased more than 30% in the past year (from 2.11 to 2.86 a gallon nationwide), and households are starting to feel the effect of this increase. The housing market is cooling, which might induce household to take out less home equity loans to finance their consumption. Payroll data shows signs of employment slowdown, and the number of initial jobless claims is up.

On the other hand, unemployment rates are still low and investment is rising at a good pace. In particular, while residential housing is slowing down, non-residential construction is picking up, which might take some of the slack from residential housing. Other business investment, like IT and equipment, is also increasing. Corporate bond spreads remain low, showing little signs of increasing risk, and global growth seem high this year.

And now inflation, what's happening to inflation? Core inflation, exluding volatile energy and food prices, has been at 3.2% in the past 3 months, and at 2.8% in the past six months. This is an unwelcome development according to Mr. Bernanke. What about inflation expectations? Measures of expected inflation and inflation risk indicate that expected inflation is on the rise, and while the current level is whithin values experienced in the last year or so, it bears closed watching. Mr. Bernanke also said that anectodal reports show that firms are having difficulty attracting workers in some sectors.

To summarize, we have an economy close to full capacity, in which inflation is already at reasonably high levels, and in which it is not clear that price increases have slowed down the "robust growth" ---above trend--- we have been experiencing in the past three years.

Before jumping to conclusions about the future course of monetary policy, we should think about policy so far. The Fed has been increasing rates for a while, and given the lags with which monetary policy affects aggregate demand, it's not so obvious that further increases are needed. One has to weigh two risks: (i) slowing down the economy by increasing rates if they are not needed vs. (ii) letting inflation increase by not raising rates. Even disregarding speculations about credibility, a new chairman, and similar arguments advanced by the press, with the unemployment rate so low, the Fed can afford raising the target federal funds rate by a quarter point (to 5.25%) at the next meeting and my guess it's that this is what they will do.


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