August 20, 2002

Reliable indicators support the Fed’s inaction

By James W. Coons

Talk of a double-dip in the summer is usually about ice cream. Not this year. With disappointing economic news and a sinking stock market, the much-debated second serving refers to renewed recession. Adding to mounting concern about the economy was the decision last week by the Federal Reserve against lowering short-term interest rates. Despite howls of criticism, the Fed did the right thing. Based on dependable measures of monetary policy, Greenspan & Co. have already provided ample helpings of what is needed to get the economy moving.

The policy arm of the Fed did acknowledge in its public statement that the health of the economy was more of an immediate issue than inflation. But it stopped short of lowering the interest rate under its control from the 40-year low of 1.75% established last December. In all likelihood, the bias toward lowering rates was adopted in order to garner a unanimous vote and show the Fed is in touch with the economy.

The Fed will not lower rates except in response to a major and unpredictable event, such as the collapse of Long Term Capital Management in 1998 or September 11, nor should it. Three reliable gauges indicate that the economic expansion now underway is sustainable and will strengthen rather than dissipate.
The first reason to expect uninterrupted growth is that real short-term interest rates are nearly zero. Real rates are simply interest rates, minus inflation. They are the ones to watch, because people make decisions based on the inflation-adjusted cost of borrowing. Also, the record of real short-term interest rates as a leading economic indicator is exemplary.

The real federal funds rate – the rate controlled by the Fed – has averaged less than 1% in fourteen quarters since 1959. Economic growth was higher in the subsequent year than in the previous year in eleven of those cases. In the other three, the timing was off by just one quarter. The relationship holds in the opposite direction, too, with high real rates usually being followed by lower growth.

A second simple indicator that is consistent with sustained and strengthening growth is the spread between long-term and short-term interest rates. A National Bureau of Economic Research study identified the difference between the yields on the 10-year and 1-year Treasury notes as the single best leading economic indicator. An analysis by the Organization for Economic Cooperation and Development noted that a similar measure has produced accurate forecasts of economic growth in economies around the world for decades.

The spread today is near a record high. The last time it widened to the current level was ten and a half years ago, as real growth was moving from zero in 1991 to 4% in 1992. Rather than affect the economy, the wide gap between short-term and longer-term rates is a signal that investors see a stronger economy and more vigorous demand for loans coming. Expectations can be wrong, of course, but this familiar pattern has reliably marked the return of economic expansion following every post-war recession.

Finally, the money supply has been growing rapidly. The measure directly controlled by the Federal Reserve – the monetary base – has expanded by 10% in the past year. It is possible to make too much out of each squiggle in money growth. But money does matter, and big swings have predictable effects on the economy. Money growth near this pace has always been associated with solid economic activity. Monetary base growth peaked five quarters before the top in economic growth associated with the 1990-91 recession. It reached a low and started rising five quarters before the subsequent trough in economic growth. Again, heading into the 2001 recession, monetary base growth peaked two quarters before economic growth. The latest surge has been large enough and lasted long enough to reliably telegraph a durable upturn in the economy.

There is no question that growth in this expansion should be slower than in previous expansions. The economy did not sink as far in the 2001 recession as usual, so there is not as much lost ground to regain. But regardless of scary headlines and gloomy prognostications, we won’t head back into recession unless and until these three simple indicators make a dramatic reversal. And that is not likely to happen without a new, major shock to the economy.

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