Reflections of a professional life-long Fed watcher: Fed-watching is unlikely to become obsolete.
The theme of this year's NABE's Annual Meeting is "Comparative Advantage in the 21st Century--Information Technology and the Professional Network." This theme is a key reflection of the challenge facing our profession and each one of us to use our vast network of information and professional contacts in a value-added manner for our clients. NABE as a professional organization has been a critical part of my network of people and ideas, and it has been my honor to serve as President and carry forward the NABE tradition of professional excellence.
I have been fortunate and somewhat atypical of the trends in our profession by staying with the same employer for over 26 years. No doubt part of my longevity reflects PNC's path of independence in a rapidly consolidating financial services industry. Another part reflects my attempt to consistently leverage my strengths and experience in the quaint endeavor we call "Fed watching" to the benefit and relevance of PNC. So, my message to you today is primarily about my reflections as a professional life-long Fed watcher but secondarily as an example of how the unique training and experience of economics can help each of us remain valuable in the marketplace for bottom-line oriented ideas and information.
My Fed-Watching Journey
The Pre-Greenspan Years
I began my Fed watching career, like Jonah, in the belly of the beast at the Federal Reserve Bank of Atlanta (FRBA) from 1974-1980, analyzing monetary policy from a normative point of view--addressing such questions as, "What is the appropriate monetary policy to achieve the Fed's dual goals of price stability and maximum sustainable economic and employment growth?" The late 1970s was a time of changing Federal Open Market Committee (FOMC) targets and instruments: reserves against private deposits (RPDs), non-borrowed reserves (NBRs), the federal funds rate, M1 and M2 target bands, reserve factors, and repurchase and matched-sale agreements. These were analyzed to devine 1/8 or even 1/16 of a percentage point moves in the target Fed funds rate. There was no FOMC statement following each meeting, no timely release of FOMC minutes, and no Fed transparency. Indeed, quite the contrary. The prevailing view at that time was that monetary policy "surprises" were an effective part of the transmission of policy to the economy and inflation.
What were the tools of the Fed watching trade in those days? There were no PCs with websites, no e-mail, no cell phones, no Blackberrys, and few financial futures markets. Instead, we used faxes and snail mail and word of mouth (there were land-line telephones). What is the result of all this progress of the past 30 years? We Fed watchers are much more productive now. It used to take me several days to make a bad Fed forecast, and now I can make one in just a few minutes.
For me, the FRBA was an excellent place to start on my Fed-watching career, not only for what I learned about the Fed but, more importantly, for all the people I met. Since then, many of those Federal Reserve staff economists have migrated to the private sector. Others have become senior administration officials, Fed policymakers, and federal government statistical agency officials as we all matured in our professional careers. I would add that many of those individuals have been leaders in NABE and other professional organizations.
Thinking back to my time at FRBA from 1974 to 1980, with Arthur Burns and G. William Miller as Fed chairmen, those were tough years for the Fed and the economy, as inflation raced ahead and economic growth stagnated, a combination dubbed "stagflation." Paul Volcker took over as Fed chairman in August 1979 and soon thereafter came the "October 6, 1979 Massacre," when M1 was elevated to the top of the Fed's food chain and interest rates were set free.
I left the FRBA to join Pittsburgh National Bank, predecessor to PNC, in May 1980. I was recruited by Jerry Jordan and Lee Hoskins (future NABE Presidents) just after the Carter Administration's failed attempt at consumer credit controls, reluctantly administered by the Fed. At that time, Fed watching was all about M1. We Fed watchers ate, drank and worshipped weekly M1 data while interest rates gyrated widely, both up and down, but mostly up from 1979 to 1981. There was a survey conducted by a Chase Manhattan economist where he called hundreds of the largest banks' economists (back then there were hundreds of banks employing economists) to get information on their bank's demand deposit accounts and add them together. Weekly M1 was announced each Thursday at 4:10 PM, later moved back to 4:30 PM, and then moved again to Fri. at 4:30 PM. We all held our breath as the Fed released the weekly M1 data, and the financial markets reacted, often violently, with the result that much money could be made or lost in a matter of minutes.
In August 1982, Chairman Volcker sent M1 to the dustbin of Fed monetary control "instruments." In 2004, William Poole, the President of the FRB of St. Louis and our 2006 Adam Smith Awardee, hosted a conference that I attended that rightfully lauded Volcker as the great inflation dragon slayer (my words). But the global economy paid a steep price for letting the inflation "cat out of the bag" and then having to put it back in again. This is a lesson not lost on the Fed and other central banks around the world. I believe this lesson is especially relevant to the current conduct of global monetary policymakers, a topic to which I will return.
The Greenspan Era
In August 1987, Alan Greenspan, NABE president from 1969-1970, was appointed Fed chairman. At that time, it was, "Alan who?" However, he guided the economy and financial markets through the October 1987 stock market crash, the short-lived stock market meltdown two years later in October 1989, and the 1990-91 recession. He presided over a record ten-year-long economic expansion during the 1990s, including the Mexican crisis, the Russian default, the Asian economic crisis, and the demise of the Long Term Capital Management hedge fund.
Greenspan is blamed by some for letting the stock market bubble form and then burst in spite of his "irrational exuberance" rumination in December 1996. He managed the financial markets through the post-9/11 market illiquidity crisis, through the so-called jobless recovery in 2002-2003, and into the ongoing economic expansion. He began the process of an orderly rise in nominal and real short-term interest rates from abnormally low levels just over two years ago, although the "conundrum", as Greenspan called it, of higher short-term and lower long-term interest rates (and narrow credit-quality spreads) remains an unexplained puzzle wrapped in an enigma.
On February 1, 2006, Ben Bernanke became the fourteenth chairman of the Federal Reserve System. The financial markets may well yet test Bernanke, just as Greenspan was tested by the October 1987 stock market crash that occurred just two months after he took office. However, I believe that in his short tenure Bernanke has started to establish his anti-inflationary credibility and build market confidence in his stewardship.
What is Likely to Lay Ahead
This historical review brings me to the point where I now need to put on my Fed-watchers cap and attempt to divine where the Fed and the financial markets are headed in the year or so ahead. In my opinion, monetary policy is in a restrictive mode that will become more evident given the lags in policy or what Bernanke referred to recently as "pipeline effects." Signals of monetary restraint include an ex-post real Fed funds rate that is close to three percentage points, decelerating real monetary base and M2 growth over the past year, and an inverted Treasury yield curve.
What could explain the "conundrum" of the 10-year Treasury note rate currently close to 4.75 percent versus 4.20 percent both one and two years ago while the Fed funds rate is up to 5.25 percent versus 3.50 percent a year ago and 1.50 percent two years ago? I will list no less than eight reasons or explanations popular in the financial markets.
First, it is highly likely that the FOMC is done or at most one 25 basis points funds rate hike to 5.50 percent from completing its tightening, with which I agree. Second, there is a global over-supply of savings outside the United States that has been invested in U.S Treasury notes and bonds, although to a lesser extent in recent quarters. A more sophisticated version of this story is that an abundance of global savings versus investments has lowered the real long-term interest rate in the United States (and globally), along with structurally faster U.S. worker productivity growth (Bernanke's global saving glut hypothesis). Third, lower long-term interest rates are a result of the market's confidence and credibility in the Fed's anti-inflation commitment. Thus, long-run inflation expectations are lower than the recent actual inflation rate, and, therefore, the real interest rate is not below its historical norm on an ex-ante basis.
Fourth, central banks have been acquiring dollars in the process of preventing their currencies from appreciating. This includes huge purchases of Treasury securities by the Bank of China with the dollars purchased to manage their currency, the renminbi (also known as the yuan). Recently, OPEC nations may also be using their funds from high oil prices to purchase Treasury securities, a replay of the petrodollar "recycling" of the 1970s.
Fifth, the flatter Treasury yield curve is a sign of a weak economy ahead putting downward pressure on inflation. The extreme case is that the Treasury yield curve inversion is signaling a recession in 2007 unless the Fed eases before year-end 2006. Sixth, hedge funds are buying Treasury notes (using leverage) and pocketing the spread between U.S. interest rates and even lower Japanese short-term interest rates. This explanation has become less compelling as the Bank of Japan ended its quantitative easing policy this past March followed by a 25 basis point hike in its overnight interest rate this past July.
Seventh, pension funds and life insurance companies are buying long-term, safe U.S. Treasury securities to match their long-term liabilities, especially the 30-year Treasury bonds. Finally, eighth, there is a flight-to-quality for Treasury securities in the wake of hostilities in the Middle East and geopolitical concerns about North Korea, Iran, Venezuela, and Iraq. This explanation is also less compelling since credit quality spreads remain very narrow.
I believe that no single one of these explanations is sufficient to account for a 4.75 percent Treasury 10-year note yield, which is below the 5.25 percent Fed funds rate. In my opinion, a combination of the first (Fed tightening done), second (global savings glut), third (Fed anti-inflation credibility), fourth (central bank purchases), and fifth (weak economic outlook) reasons is a convincing explanation.
I will now return to my earlier comments about global central bank policies. In early August, both the European Central Bank and the Bank of England raised their short-term benchmark interest rate by 25 basis points to 2.75 percent and 4.75 percent, respectively, and strongly hinted that further rate hikes will follow in 2006. Last May, the Bank of Canada raised its overnight rate by 25 basis points for a seventh consecutive time, putting it at 4.25 percent. In addition, the Bank of Japan ended its "quantitative easing" policy in March and ended its "zero" interest rate policy by raising its overnight rate to 25 basis points in July. Finally, the Bank of China raised its lending rate twice thus far this year.
Despite the widespread move towards tighter monetary policy around the globe, the U.S. fixed income market has taken little notice, especially during the summer months, when Treasury note rates declined by close to 50 basis points. It would have been expected that U.S. Treasury securities yields might have risen in recent months, as rising interest rates in Europe and Japan would make U.S. Treasury securities less attractive. With much of the world's investment activity conducted in dollars, euros, and yen, prospects of higher interest rates in Europe and Japan should be putting upward pressure on U.S. Treasury yields, as investors demand a higher yield in order to continue purchasing dollar-denominated assets. This is another aspect of the conundrum discussed earlier.
This is especially true given the extent to which both foreign individuals and institutions have accumulated dollar-denominated assets in recent years and could be looking to diversify their portfolios. Typically, monetary policy tightening occurs when central banks raise interest rates in an atmosphere of rapid economic growth and rising inflation. In the current circumstances, monetary policy tightening is better characterized by central banks attempting to return monetary policy to a more neutral stance, aiming to fend off potential inflationary pressures as economic growth strengthens. With many economies now in the midst of self-sustaining expansions, it is fitting for central banks to be draining any excess monetary stimulus.
With the FOMC nearing or at the end of its tightening cycle while other major central banks are clearly not finished, the dollar is vulnerable as interest rate differentials move in favor of foreign currencies at the expense of the dollar. For some time, analysts have been warning of the potential dire consequences if the United States does not address its gaping current account deficit. Thus far, foreigners have been willing to finance the U.S. current account deficit by accumulating large quantities of U.S. Treasury and corporate securities. It is reasonable to assume, however, that after having accumulated such vast quantities, foreigners would at some point lose their appetite for U.S. securities--in particular, U.S. Treasury debt--and become unwilling to purchase more. This could send the U.S. dollar significantly lower and send yields on U.S. Treasury securities sharply higher, causing U.S. economic growth to stagnate or worse. Fears of this "doomsday" scenario have been compounded in recent months as foreign central banks, including those in Sweden, Russia, and Qatar, among others, have publicly discussed their intent to diversify their foreign exchange reserves.
In reality, this portfolio diversification has been occurring for some time, albeit more quietly than has been the case in recent months. As of Q1 2006, global foreign exchange reserves totaled $4.35 trillion, of which 66.3 percent were held in U.S. dollars, but as recently as 2002 the U.S. dollar accounted for over 70 percent of total foreign exchange reserves. The euro's increasing stature as a global currency has provided foreign central banks with an alternative to the U.S. dollar, and the trend towards greater diversification is likely to continue.
Still, I attach a very low probability to any sudden, large-scale flight out of U.S. Treasury securities. After all, with foreign central banks holding such massive amounts of these securities, any large-scale liquidation of these holdings would result in huge capital losses around the globe--think of it as the financial equivalent of mutual assured destruction. Another factor that will provide support for the U.S. dollar is high crude oil prices, given that oil is priced in U.S. dollars. Oil exporting nations have accumulated vast amounts of U.S. Treasury securities and, while many of these nations are moving towards diversifying their asset holdings, the sheer volumes involved means the pace of this diversification will probably be modest, particularly with crude oil prices likely to remain high for the foreseeable future.
While there is much hand-wringing in the United States over China's exchange rate policy, or lack thereof, it should be noted that this policy has helped result in China becoming the world's second largest holder of U.S. Treasury securities, behind Japan. Intervention in the foreign exchange market has led to both countries accumulating the vast sums of U.S. dollars used to purchase Treasury securities. While the Bank of Japan has not intervened in the foreign exchange market since 2004, the Bank of China continues to manage the renminbi. Were the renminbi allowed to float freely, China would be left with little cause to continue purchasing U.S. Treasury securities, at least not nearly to the extent of its purchases in recent years.
Thus, while the doomsday scenario of a sudden and massive flight out of U.S. Treasury securities is highly unlikely to play out, I do expect foreign central banks to continue lessening their exposure to U.S. securities. This diversification will contribute to a steady, but orderly, decline in the U.S. dollar, such as that which prevailed between 2002 and 2005. While this could contribute to higher U.S. inflation and interest rates, these effects are likely to be modest.
Returning my attention to the U. S. economy, my single biggest concern about the domestic economy and financial markets is that price of crude oil remains near $70/barrel, which is acting as a brake on U.S. and global economic growth. There is a double-edge sword of an oil price "shock" which can cause both slower growth and temporarily faster inflation. This is the Fed's worst nightmare, as it was back in my days at the FRBA in the mid-to-late 1970s.
I am not in the stagflation camp. My forecast is real GDP growth of 2.6 to 2.9 percent annually in the latter half of 2006 as the lagged impacts of higher energy prices and interest rates works through the U.S. economy. For all of 2007, my real GDP growth forecast is a below-potential 2.5 percent to 3.0 percent if the price of crude oil averages below $70/barrel. In addition, my forecasts for the core PCE deflator and CPI are 2.3 percent and 2.6 percent, respectively, from December 2005 to December 2006 and 2.0 and 2.3 percent, respectively, from December 2006 to December 2007.
My top four downside risks to the economy and upside risks to inflation are: 1) terrorism in the United States or Saudi Arabia, 2) crude oil prices up to new record highs over $80/barrel, 3) foreign investors abandon the U.S. stock and bond markets because the dollar goes into a disorderly tail-spin, and/or 4) housing construction, sales, and prices suffer a sever downturn with an associated negative impact on consumer spending and lenders' residential mortgage portfolios.
I will conclude by focusing on one major monetary policy option publicly favored by Bernanke and several other current Fed officials, which is explicit inflation targeting as adopted by numerous other central banks around the globe (Britain, New Zealand, Australia, Canada, and the European Union). The devil of an inflation-targeting regime is in the details: Which inflation measure to target and over what time period (ex-ante or ex-post) and what target or target range? Also, the Fed needs to establish decision rules about how to react as actual inflation approaches or breeches the top/bottom of the target range given the long lag between monetary policy actions and inflation.
Still, adopting and announcing an explicit inflation target could be key for the Bernanke Fed to maintain the high level of anti-inflation credibility built up in the market during Greenspan's long and distinguished tenure. It would also be another important step in the increasing transparency of Fed policy. Therefore, I expect the FOMC will adopt an explicit numerical inflation target range before the middle of next year. This recommendation could come from the FOMC's Communication Committee headed by Fed Vice Chair Donald L. Kohn.
Finally, the good news is that despite the Fed's drive for increase transparency, there will still be a job for Fed watchers who can correctly anticipate the underlying economic and inflation trends and relate them to the future course of Fed policy actions, interest rates, and other financial markets. This brings me back to my initial point that NABE's network of professional contacts, its excellent programs, and its professional development opportunities have been a crucial part of my remaining relevant to the test of the marketplace for bottom-line oriented information for well managed businesses.
I want to close by thanking the NABE Board, and our Executive Director and her staff for their dedication to our mission during the past year. Looking forward, continued development of the NABE Foundation in both funding and programs would further enhance the legacy of NABE on our profession's advancement. It has been an honor and a privilege to serve as your President for the past year.
I want to thank my PNC colleague Richard Moody for his assistance in preparing my remarks, but I alone am responsible for their contents.
Stuart G. Hoffman is senior vice president and chief economist for The PNC Financial Services Group and was NABE President for 2005-2006. Previously, he was a senior economist at the Federal Reserve Bank of Atlanta. Business Week named him the most accurate economic and interest rate forecaster for 2004, and he is frequently quoted in the business press. He also serves on the Board of Directors of the Pennsylvania Partnership for Economic Education and the Economic Club of Pittsburgh--the local chapter of NABE. He is the past chairman of the American Bankers Association Economic Advisory Committee. He received an undergraduate degree from Pennsylvania State University and a M.A. and Ph.D. degrees from the University of Cincinnati, where he was a Charles Phelps Taft Memorial Fellow. In 2004, the Univeristy of Cincinnati honored him as a Distinguished Alumnus.
NABE Presidential Address, presented at the Annual Meeting, September 11, 2006. This article was updated in early October and based upon information available at that time.
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|Author:||Hoffman, Stuart G.|
|Date:||Oct 1, 2006|
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