This week’s tentative equity market rally has restored faith that the U.S. economy is on course to a “soft landing,” with the supposed threat of an inflationary overheating eliminated without significantly increasing the risk of a serious growth pause. Even as expectations remain in place for at least one more Fed rate hike amid widespread indications that the economy is already slowing significantly, confidence prevails that Alan Greenspan’s deft touch will ensure a benign outcome. To be sure, no evidence available now suggests that recession looms. Nevertheless, the sanguine outlook appears vulnerable to risks implicit in the Fed’s backward-looking fine-tuning paradigm. Policy now appears close to reaching a critical “tipping point” beyond which the mythical soft landing could become an extremely bumpy ride.     

Nominal Gross Domestic Product versus Fed Funds Rate

The accompanying chart, showing the close correspondence between changes in nominal GDP growth and the federal funds rate since the mid-1980s, helps illustrate why. For the bulk of this period, the Fed probably was not directly targeting nominal growth. Presumably, policy makers were reacting to changes in data reflecting both real growth and inflation, and moving the interest rate target accordingly.

Recently, though, there have been rumblings that the central bank’s task of imposing sufficient economic "restraint” will not be complete until the funds rate is moved up to a level at least equal to growth of nominal GDP. The thinking apparently is that since nominal GDP approximates an economy-wide nominal rate of return, policy will not be restrictive enough as long as this return exceeds the marginal cost of funds. Indeed, the chart suggests further increases in the funds rate relative to the level of nominal GDP growth would threaten to bring about a significantly sharper deceleration in economic activity than now seems apparent.  For the Phillips Curvers grouped around Fed Governor Laurence Meyer, the nominal GDP rationale also offers an operational guidepost for their effort to boost the unemployment rate in order to quell the purported inflationary pressures of a tight labor market.

The potential for error arising from this conceptualization is enormous. Note on the chart that changes in the funds rate have typically lagged nominal GDP by about a year, as the Fed responds to data from prior quarters to set contemporaneous policy. This delayed-reaction approach is unavoidable under the central bank regimen of setting policy based on statistical portrayals of past economic performance rather than focusing on forward-looking price signals. The risks, though, could be magnified significantly in the current environment. Policymakers skeptical about recent indications of slowing growth, intent on setting policy based largely on the strength of the past few quarters, would be continuing to hike rates into the teeth of a rapidly decelerating expansion. The second quarter GDP data slated for release July 28 likely will show a significant slowing in reported nominal growth from the 8.5% annual rate of the past two quarters to a level around 6%. Nevertheless, that would still put the average of the past three quarters at a annual rate of about 7.5%, much too high for policymakers looking for an excuse to continue turning the monetary tourniquet tighter. 

Another source of error in this approach arises from the distortions involved in isolating the inflation from the real components of both nominal interest and growth rates. The reported inflation component of nominal GDP has more than doubled since the 1998 fourth quarter, to about 3% annualized, due chiefly to the rise in oil prices. The oil price increase, however, has entirely reflected a change in relative prices rather than a decline in money purchasing power, as indicated by the dollar’s sustained strength relative to gold and major foreign currencies. To the extent, though, that the nominal funds rate is being lifted in accordance with an overstated inflation element of nominal GDP, the real funds rate has already been raised to a level well above that which can be justified by market fundamentals. Correcting for the oil-price distortion of the inflation estimate converts the current 6.5% nominal funds rate to a real rate no lower than 5-5.5%, compared to the current 4% yield on the inflation-adjusted Treasury. That yield in itself is 25-50 basis points above historic real-rate norms, another indication that the Fed’s campaign has already lifted the entire yield structure beyond anything justified by inflation risk.                      

Into this mix next week steps Fed Chairman Alan Greenspan, who is scheduled to deliver his semi-annual Humphrey-Hawkins testimony to The Senate Banking Committee on July 20. The thinking from here is that Greenspan is probably ready to call a halt to the tightening exercise before it causes him real political problems. His speech this week to the governors echoed many of the New Economy themes he first explored last month. It again suggested that he sees an expanded capacity for non-inflationary growth attributable to the productivity improvements spurred by the information technology revolution. A major question, though, remains as to whether he has the sway within the Fed power alignment to piece together a consensus against further action. Next week’s hearing might still come too soon to offer a definitive answer.