By JOHN LIPSKY and JAMES E. GLASSMAN July 1, 2004;
The Federal Reserve's first rate hike in more than four years proved to be anticlimactic for financial markets, as it was about as well-advertised as these things can be.
The Fed's move was anything but trivial, however, as it kicked off a policy transition that gradually will end the Fed's sustained stimulus that began back in 2001. There are good reasons to anticipate a relatively muted investor response, however: Market prices already anticipate that short-term interest rates will be pushed back to more normal levels over the coming year. In contrast, the Fed's previous policy tightening, in 1994, triggered a massive global bond selloff, as investors were surprised repeatedly by Fed actions in response to an unexpectedly robust economic expansion.
* * * The market's uneventful response to the Fed's rate increase makes it easy to miss the key implications of recent developments. In broad terms, the power of monetary policy action to combine both long-term inflation goals with short-term stabilization tasks has been confirmed, even in the context of globalized and deregulated financial markets -- and a series of unusual shocks.
It's easy to forget that only one year ago, the threat of deflation was judged widely to represent the United States' most immediate economic danger. In fact, many analysts and investors predicted at that time that the Federal Reserve was about to conduct "unconventional" policy easing -- that is, buying securities directly from private investors -- something that had been attempted only once, when the Fed pegged all interest rates during World War II. It didn't happen last year, but the worries about low inflation weren't illusory -- the core Personal Consumption Expenditures (PCE) chain price index dipped below 1% last winter on a rolling 12-month basis for the first time since the measure's inception in 1959.
From today's vantage point, the U.S. economy's renewed economic vigor is a reminder that monetary policy remains a potent short-term stabilization tool. Not only were deflation worries building a year ago, but many expressed concern that Fed policy would be inadequate to overcome the allegedly irresistible contractionary impact of the late 1990s economic and financial imbalances. The classic skeptics' image of the Fed pushing on a string once again became cliché. Nonetheless, the current U.S. upturn overcame a series of shocks as potentially threatening as those of the late 1920s.
The restoration of robust U.S. growth while avoiding deflation should not obscure the Fed's success in reaching its key long-term goal of price stability. Twenty-five years after the Federal Reserve -- under Chairman Paul Volcker -- administered draconian rate hikes to combat double-digit inflation, Alan Greenspan was able to describe the U.S. economy as having entered a "zone of price stability." Over most of the intervening span, Fed policy could be described as one of "opportunistic disinflation." That is, the Fed didn't set out to create downturns. However, when slumps occurred -- thereby ratcheting down inflation -- the Fed would act preemptively to hold onto the inflation gains. In practice, this sustained strategy eventually achieved price stability amidst two long economic booms and an unprecedented bull market in financial assets.
Of course, the Fed had no intention of triggering a recession when it tightened cautiously in 1999 and early 2000. In that sense, the 2001 economic downturn was an accident. Presumably, the Fed would not have tightened at that time had policy makers known what was coming. Nonetheless, the result was the final step to price stability, as the economy contracted in 2001, Thus, the Fed's task has become one of preserving -- not establishing -- low inflation. By implication, a new policy approach will be needed to supplant opportunistic disinflation.
For now, the Fed is on a path to end its current stimulus by renormalizing short-term interest rates. Despite claims by some observers that the Fed has waited too long to begin tightening, the Fed's move yesterday marks one of the earliest ever undertaken, when judged using the factors that typically guide such actions, including the current inflation rate and the likely margin of excess capacity. For example, the Fed rarely has begun to withdraw its stimulus before employment has returned to its pre-slowdown peak.
Today, however, total employment is 1.3 million lower than at the recession's onset in early 2001. In other words, Fed officials appear to be intent on preserving price stability, now that it has been attained. The FOMC's policy statement made it clear that the Fed "will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability."
Investors may be confused about the Fed's intentions, because the earlier cut in the Fed funds rate to 1% was unprecedented. However, the funds rate is no more stimulative today than in other, similar periods when judged in real (that is, inflation-adjusted) terms. For example, today's 1.25% nominal funds rate -- with the year-on-year increase in the Fed's favored core PCE price index at 1.5% -- is no lower in real terms than the 3% funds rate was a decade ago when inflation was close to 3%. Presumably, the Fed's aim is to withdraw its stimulus at a pace that will return short-term interest rates to neutral by the time the economy reaches full employment. That likely will require the funds rate to be raised to around 4%. Even if it takes a year or more to reach that point, the persistence of substantial slack in the economy ought to keep inflation in check.
Gradual Fed tightening well ahead of schedule signals that the central bank is moving its sights back to its primary long-term goal of price stability. In practice this is likely to mean keeping inflation in the 1% to 2% band for year-on-year increases in the core PCE deflator that has been maintained since 1996. Although the Fed has never acknowledged any specific target range, by implication a sustained 1% to 2% year-on-year increase in core inflation would represent a fair approximation. Such an outcome likely would match the Fed's fundamental goal of keeping inflation low enough that it does not distort investment decisions.
If the Fed is successful in allowing the economy to return to full employment while maintaining price stability, the result will be a positive surprise for investors. Although financial market participants appear to have assumed that the Fed will be tolerant if inflation rises into at least a 2% to 3% range -- a conclusion that is consistent with surveys of inflation expectations -- the Fed's early transition back to normal short-term rates contradicts that claim. Securing price stability therefore will establish a constructive backdrop for financial assets.
Obviously, equity investors are nervous about the prospect of higher Fed interest rates. However, vigorous noninflationary growth creates a more positive environment for corporate earnings than the slower growth that originally motivated the Fed to lower interest rates to emergency levels. Naturally, long-term interest rates would be expected to rise as the economy improves, but long-term rates have climbed significantly in anticipation of Fed tightening. In this context, the Fed's resolve to maintain price stability is the best way to keep bond yields relatively low.
Mr. Lipsky is chief economist, and Mr. Glassman senior economist, at JP Morgan.
