By Craig Torres and Carlos Torres
Bloomberg
October 22, 2006
SourceOct. 23 (Bloomberg) -- Federal Reserve policy makers opened confidential briefing books at their Aug. 8 meeting to find disturbing news between the green covers: Their assumptions about economic growth and inflation may be too optimistic.
The Fed's number-crunchers, rushing an analysis based on data that arrived about a week before, threw out previous conclusions about how fast the economy can grow without fueling inflation. They concluded that the speed limit is lower than previously thought -- and they lowered it still further in the ``Greenbook'' for the September policy meeting.
The staff's revisions, reflected in minutes of the last two meetings, shake the foundations of the fast-growth, low-inflation economy Americans enjoyed from 1995 to 2005. The implication: Unless the economy slows more than the Fed now expects, the central bank may have to resume raising interest rates sooner rather than later to control inflation.
``The tide is shifting,'' says David Greenlaw, chief U.S. fixed-income economist at Morgan Stanley in New York. ``I do not think the Fed is out of the game just yet.''
Fed policy makers meeting this week are likely to hold the benchmark lending rate at 5.25 percent, according to economists surveyed by Bloomberg News. Even so, comments by Fed officials suggest the staff's analysis is affecting their thinking about what may lie ahead.
Kohn and Moskow
Vice Chairman Donald Kohn said Oct. 4 that any further jump in inflation would be ``adverse'' and ``require policy actions.'' Chicago Fed President Michael Moskow said Oct. 13 that ``some additional firming of policy may yet be necessary'' to get inflation down.
The estimates are the work of dozens of economists among the 200 PhDs who work for the central bank. Vincent Reinhart, Karen Johnson and David J. Stockton, the heads of the three key divisions -- monetary affairs, international finance and research and statistics, respectively -- are known informally as ``the barons.''
The fruit of their labors, the Greenbook, carries so much weight among members of the rate-setting Federal Open Market Committee that former Governor Laurence Meyer once dubbed it ``the 13th member of the FOMC.''
If anything, the staff's views have taken on greater influence under Chairman Ben S. Bernanke. Former Chairman Alan Greenspan, a professional forecaster, often rejected staff analyses in favor of his own views. Bernanke said last year his academic work didn't train him for ``current analysis'' on the U.S. economy.
Time Running Out
In effect, policy makers were told last month that time is running out for inflation to fall. The forecasters expect ``only a small gap'' between what the economy can produce running at full speed and the actual growth rate over the next several quarters. That means any unexpected acceleration in growth might well heat up inflation.
By 2008, according to meeting minutes, the staff expects the economy to be roaring ahead at close to its speed limit, making it more urgent to get inflation under control now.
``We are getting growth that is very close to potential, and that is the important point for monetary policy,'' says John B. Taylor, a Stanford University economist who was Treasury undersecretary for international affairs from 2001 to 2005. ``There will be increased tightening'' if the ``core'' inflation rate -- which excludes food and energy costs -- ``remains in the 2.5 percent range,'' he says.
Comfort Zone
Core prices, as measured by the Fed's preferred index based on personal consumption expenditures, are up 2.5 percent over the past year, above Bernanke's ``comfort zone'' of 1 percent to 2 percent.
The economy will grow 2.5 percent over the second half of 2006, accelerating to a 2.9 percent rate by the third quarter of 2007, according to the median estimate in a Bloomberg survey. While a 25 percent decline in oil prices since July will reduce the overall rate of inflation, core measures may remain above the Fed's comfort zone.
``There's no reason to expect any rapid decline in core inflation from an economy that grows in a 2.5 percent range,'' says Allen Sinai, president of Decision Economics Inc. in New York. ``The Federal Reserve will make that conclusion.''
Not all Fed policy makers are convinced they need to ratchet up their vigilance against inflation because of the staff's new estimates. Some, like San Francisco Fed President Janet Yellen, remain concerned that the economy may slow down too much, perhaps tipping into a recession.
Balancing Act
Policy makers are performing a ``balancing act,'' trying to bring inflation down without putting the economic expansion in danger, Yellen said Oct. 16. St. Louis Fed President William Poole said the same day that the chances of an interest-rate cut and an increase by the central bank are about equal.
The debate at the Fed is mirrored on Wall Street. JPMorgan Chase & Co. figures the economy's speed limit has dropped to around 2.7 percent from around 3.5 percent in the late 1990s. The New York firm expects at least three more interest rate increases by the end of June.
Others remain confident the economy will slow more than enough to bring inflation down. Economists at Goldman Sachs Group Inc. in New York expect the Fed will reduce rates five times next year, ending 2007 at 4 percent.
Below Trend
``You are going to be growing below trend, and you will be creating slack,'' in the economy, says Jan Hatzius, chief U.S. economist at Goldman Sachs. The Fed's forecast ``generally sees less slack than ours.''
The Fed staff's view stems partly from revised figures published by the Commerce Department July 28 that showed the U.S. economic expansion over the prior three years wasn't as robust as previously estimated. Instead of expanding at a 3.5 percent rate from 2003 through 2005, the economy actually grew at an average 3.2 percent pace.
The revisions chipped away at two important pillars of non- inflationary growth. First, output per hour grew less than previously reported, rising 2.3 percent last year instead of 2.7 percent. Second, business purchases of equipment and software grew at an average annual rate of 6.3 percent from 2003 to 2005, down from a previous estimate of 8.6 percent.
``A lot of what we have been hearing from the Fed is that high-tech spending has been a driver of recent productivity gains,'' says JPMorgan economist Michael Feroli, a member of the Fed's forecasting team from 2003 through 2005. ``It just doesn't look as bright as it did a few months ago.''
A Downward Slide
The Fed staff viewed the revisions in the context of new research by its five-person team of labor experts led by William Wascher, the minutes show. In a 97-page research paper published by the Brookings Institution earlier this year, the labor experts concluded that the proportion of the U.S. population participating in the labor force was starting a long downward slide.
``Such a slowing in labor input would, in turn, reduce the sustainable rate of economic growth'' unless there is another surge in productivity, they concluded.
Economists don't completely understand what drives productivity booms and how long they last. Dale Jorgenson, a Harvard University economist who has written books on the topic, says the U.S. economy will continue to enjoy rising wealth as workers generate more output per hour with the aid of technology.
``The new productivity trend is still with us,'' says Jorgenson, who estimates the economy can grow 3 percent without much inflation.
The Fed staff analysis reflects more concern about what even a slight decline in output per hour might mean for the economy as labor force growth slows.
The staff ``has to be a little more conservative, hope for the best, and prepare for the worst,'' says JPMorgan's Feroli.
To contact the reporters on this story: Craig Torres in Washington at
ctorres3@bloomberg.net Carlos Torres in Washington at
ctorres@bloomberg.netLast Updated: October 22, 2006 19:19 EDT