Where is neutral? It's a question heard more often in the financial markets now that the Federal Reserve is preparing to raise the federal funds rate on June 30 for the ninth time in a year. At an expected 3.25%, the funds rate would be the highest since September, 2001. But is that the rate at which monetary policy shifts into neutral?
That is, has the Fed finally lifted short-term rates from a level where they stimulate the economy to a point where they neither help nor hinder growth while controlling inflation? That's when the markets can rest easier, knowing that the Fed's work is done.
To get an answer, some Fed watchers look at historical links between growth and inflation and point to a neutral rate of about 3.5%. Others look at trends in the real funds rate -- the fed funds minus inflation -- and arrive at 4.25% or so. When asked about a specific rate for neutrality, Fed Chairman Alan Greenspan offered some of his finest obfuscation before Congress on June 9, finally saying: "We probably will know it when we are there."
But getting there may be trickier than in the past. In today's world, massive amounts of money flow into U.S. markets from overseas, exerting downward pressure on long-term interest rates. The dollar's value is being propped up as foreign governments try to protect their export industries. And because of fierce competition from the credit markets, banks are loosening their lending standards even as the Fed wants to curb borrowing.
The globalization of money means that formulating monetary policy is more difficult than ever. Policymakers face a critical challenge: How do you get to neutral in the U.S. when the agendas of international investors, companies, and central banks increasingly conflict with U.S. policy goals?
As Greenspan admitted in a June 6 speech beamed to the International Monetary Conference in Beijing: "The economic and financial world is changing in ways that we still do not fully comprehend." To the extent that global influences are a factor in the current failure of long-term rates to follow the Fed's hikes in short-term rates, then a neutral federal funds rate might well be either lower or higher than history would suggest.
ONE ARGUMENT GAINING FAVOR for a lower neutral rate is the so-called global savings glut. The idea was first advanced by former Fed governor Ben S. Bernanke, now on tap to head the President's Council of Economic Advisers, as part of his analysis explaining the huge U.S. trade deficit. The glut arose as emerging-market nations shifted from net borrowers to net lenders in the capital markets, he says, while industrialized nations such as Germany and Japan continued to accumulate savings. One result was a downward push on global rates.
Because of the U.S.'s better economic performance, American yields have remained above those in Europe and Japan, even though the rush of foreign money seeking higher returns in the U.S. has boosted the prices of American bonds and held down yields. By opting for the best payout, investors around the world are shifting away from "home bias," the tendency to invest savings domestically. This structural change in global capital flows means that the bond market's recent performance may be telling the Fed that a lower funds rate is consistent with the new trends in global finance.
OF COURSE, THERE ARE OTHER possible reasons long yields have failed to respond to Fed tightening. The bond market may rightly or wrongly see weakness in the economy. Perhaps the pressing need to bolster the pension funds of aging developed nations is boosting demand for bonds. Huge purchases of U.S. securities by foreign central banks is another explanation, as foreign governments act to control their currencies.
For his part, Greenspan has appeared unimpressed by any of the above ideas to explain the bond market's behavior over the past year. But even if they don't understand the reasons, policymakers must consider whether the current low level of long rates is too stimulative to be consistent with the Fed's goal of containing inflation. If so, then the new neutral for the funds rate might be even higher than historical experience would suggest.
Already, some evidence supports this view. First, despite the Fed's eight rate hikes, borrowing conditions for consumers and businesses in both the credit markets and at banks remain exceptionally easy. Second, low rates continue to boost wealth in the household and corporate sectors. Finally, cheap mortgages have kept the housing market red-hot and given more consumers access to low-rate home-equity loans, which fund consumer spending.
THE DIFFICULTIES OF FINDING an optimal policy rate in an increasingly open global economy put greater emphasis on the monitoring of current data and whether demand is strong enough to stoke inflation pressures. Right now, the data show that the economy has blown past its soft patch and is on the road to stronger growth.
The industrial sector, where the economy's recent softness has been concentrated, rebounded in May, with manufacturing output posting a 0.6% jump. True, May retail sales fell 0.5%, pulled down partly by falling gasoline prices, but that followed a huge 1.5% rise in April. These numbers suggest that real gross domestic product is growing this quarter at an annual rate in the neighborhood of 3.5% to 4%. And forecasters surveyed by BusinessWeek project growth in the coming year to average a healthy 3.4% (page 104).
Such a growth rate used to trigger inflation worries. But as the late 1990s proved, structural changes -- increased productivity, globalization, and competition -- enable today's economy to grow at a much faster pace without encountering the capacity restraints or labor shortages that once accelerated price pressures.
The May readings on producer and consumer prices were generally tame, especially for goods. Because of a drop in oil prices, producer prices for finished goods fell 0.6% from April. Excluding food and fuel, core prices were up 0.1%, or a modest 2.6% from previous-year levels. The recent decline in commodity prices suggests a further slowdown in core producer prices. Consumer prices also slipped in May, by 0.1%, with core prices up 0.1%.
For the Fed, however, the crucial inflation test will be in the service sector, because service companies are much more insulated from the deflationary trends of global competition and on the whole have not seen the productivity leaps made by U.S. manufacturers. The newest worry is rising labor costs coupled with slower productivity growth, which could trigger price hikes for services. In its June 15 Beige Book, a roundup of regional economic activity, the Fed noted that labor markets were improving, with several reports of shortages of some skilled workers.
Undoubtedly, policymakers will be monitoring the price indexes and labor market trends with more than the usual vigilance over the next few months. Trends in these areas will give the best signals of whether the Fed has achieved its quest for a neutral funds rate.
By James C. Cooper & Kathleen Madigan