Market should prepare for autumn rate “exit”
Could the first increases in short-term U.S. interest rates come much earlier than most forecasters expect, perhaps as soon as September or November 2010?
In the last four expansions, before this one, rates started rising 27 months, 48 months, 33 months and 31 months after capacity utilization had hit its low point.
Three of these observations lie in a narrow range of 27-33 months. Rates rose after an average lag of 30 months. The fourth reflected the unusually sluggish recovery after the last deep downturn ended in January 1983. Rates did not start to rise until four years later in January 1987.
Including this very deep recession pushes up the average to 35 months. If the Fed’s behaviour follows past practice, policymakers will not begin to boost the federal funds target until the end of 2011 or even the first half of 2012. That would be around 30-35 months after the recent cyclical turning point in July 2009. It would give the economy plenty of time to reabsorb the slack created by the recession and for the expansion to prove itself self-sustaining.
But another way to look at the problem is to ask how much of the slack created by recession is re-absorbed before the central bank begins to tighten. In the last four recessions, capacity utilisation fell by 16.8 percentage points, 18.2 points, 8.2 points and 13.6 points respectively (an average of 14.2 percentage points).
The Fed announced its first rate increase when utilisation had climbed back by 11.7, 11.0, 4.0 and 4.8 percentage points respectively (for an average of 7.9 percentage points). The first rise came when about 55-60 percent of the slack created during the preceding recession had been reabsorbed.
In the most recent downturn, utilisation dropped by 14.4 points (close to the average). So far it has climbed back 4.2 points (about 30 percent). It would need to climb another 3.7-4.4 percentage points to make the total gain 7.9-8.6 points before the Fed would be likely to start boosting the cost of short-term borrowing.
But utilisation rates have actually been rising quite rapidly, on average by about 0.4 points per month since July 2009. The recession has proved far more V-shaped than many forecasters believed possible last year. If the recovery continues at this pace, the first rate rise would be due sometime between November 2010 and January 2011.
TALKING ABOUT EXIT
For the moment, rate-setters on the Federal Open Market Committee (FOMC) insist that low levels of resource utilization, subdued inflation and stable inflation expectations are “likely to warrant exceptionally low levels of the federal funds rate for an extended period.”
This is very similar to the phrase the Fed used last time around (“policy accommodation can be maintained for a considerable period”) to shape market expectations and indicate rate rises were some way off. The “considerable period” language was dropped in January 2004, six months before the Fed announced its first rate rise on June 30.
The (intentional) similarity has led many observers to conclude that while the Fed retains the “extended period” formula, the first rate rise is at least six months in the future. Speculation about when the first rise will be announced has been replaced by speculation about when the Committee will drop the extended period formula.
Having originally encouraged the parallel, the Fed is now keen to downplay it. Federal Reserve Bank of Kansas City President Thomas Hoenig has already argued economic and financial conditions have changed sufficiently that the extended period expectation was no longer warranted (Jan minutes) and that it could lead to the build of new financial imbalances (March minutes).
Other Committee members seem more worried dropping the extended period language now would cause the bond market to start pricing an imminent rise in short rates within six months, starting the tightening cycle before the Fed is ready.
To bridge the gap, the Committee has agreed its “forward guidance” is no longer conditioned “on the passage of any fixed amount of calendar time.” Extended period could now mean anything from a couple of months to several years; it is no longer meant to indicate about six months. Instead the forward guidance is explicitly conditioned on the evolution of the economy.
The extended period language has now been emptied of any useful content. It means the Fed is not ready to raise rates immediately, and sees no imminent reason to boost them, but could do so at any time, with only minimal warning.
Flexibility comes at the price of reducing clarity and usefulness in communications. As usual, it is not what the Fed says but what it does that matters. The Fed is not offering bond investors a free option.
HOW MUCH SLACK?
More worrying, crude measures of the amount of unused capacity such as capacity utilisation numbers may be overstating how much slack the economy must be reabsorbed before price pressures start to build and the Fed needs to start exiting from its ultra-low rate policy.
Most observers cite the current low level of capacity utilisation in manufacturing (69 percent) and compare it with
the long-run average (79.2 percent between 1972 and 2009) to show there are substantial spare resources.
In other columns, I have noted that the aggregate amount of spare capacity may be misleading because spare capacity is distributed very unevenly throughout the economy.
Most of the slack is concentrated in primary and secondary processing industries such as steel, cement, glass and auto
parts. There is much less in basic extractive industries such as mining and oilfields, and among makers of finished consumer goods and business equipment.
Even at the aggregate level, utilisation has not been constant over time. Utilisation rates averaged 81 percent in the late 1970s, 78 percent in the 1980s, and 81 percent during the 1990s, measured from one peak to the next, using cyclical turning points defined by the National Bureau of Economic Research (NBER)’s Business Cycle Dating Committee.
But in the most recent expansion (March 2001 to December 2007) average utilisation dropped to just 75.8 percent — a full 5.15 percentage points lower than in the previous cycle. http://blogs.reuters.com/great-debate/wp-admin/post-new.php
Utilisation fell less than 2 points among crude processors, but by more than 4.5 points for primary and semifinished processors and the same for finished goods makers. The peak utilisation rate during the last cycle (79.6 percent in February 2006) was barely above the trough rate during the cycle before (77.2 percent in April 1991).
Low-inflationary growth during the 2000s was mostly driven by offshoring of production to China and the rest of Asia and the existence of large amounts of spare capacity in the U.S. manufacturing system, even at the height of the “boom.”
If we use the last-cycle average (75.8 percent) as the true measure of the economy’s non-inflationary potential rather than the four-cycle average since 1972 (79.2) the amount of slack in the economy falls by around one-third, from 10 percentage points to just 6.5.
Assuming interest rates have to start rising before the economy hits its potential output, they would need to be trending upward before utilisation reaches 75.8 percent. With utilisation currently rising 0.4 points each month, the first rate increase is now within the 12-month horizon.
If the current rate of recovery is sustained, capacity data and experience from previous cycles suggests the first rise in interest rates is likely to come this autumn.