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This is no time for Fed neutrality

Marie-Josée Kravis

September and October are usually cruel months for stocks, but markets were energized, at least briefly, this week with the news that the U.S. National Association of Purchasing Managers (NAPM) index had reached 47.9 in August, up substantially from 43.6 in July. Nonetheless, a score below 50 indicates contraction of activity, which raises the question: Why the excitement about a number that confirms that U.S. manufacturing has been contracting for 13 consecutive months? Much ado about nothing?

Not quite, because the NAPM index was markedly higher than anticipated, and coincided with an increase in the new orders index to 53.1 in August, compared to 46.3 in July. Twelve out of 20 manufacturing industries reported higher orders, and seven out of 20 recorded increases in production. In fact, the production index jumped to 52.2 in August versus 46.4 in July. Could the bottom be near?

As always, there were commentators rushing to harried conclusions forecasting an imminent turnaround and a nascent bull market. Many had the temerity to declare that further Fed easing was now unnecessary, and that the economy was well on its way towards full recovery. Granted, numbers released on Tuesday — if sustained — would be consistent with growth of about 1.9%, but one month does not a trend make. Until we can record many months of steadily improving data, it might be wise to avoid popping too many corks.

First, on the question of Fed easing, the challenges are complex. If a capacity or capital goods overhang does actually exist, it is correct that Fed loosening is unlikely to induce short-term business investment. Nor is credit creation likely to grow quickly, despite rapid growth in money supply, because commercial banks remain wary of the future earnings and prospects of borrowers. On the consumer side, therefore, it is imperative that the central bank help sustain consumer spending. In this regard, real interest rates are high. With the personal consumption expenditures (PCE) deflator running just over 1%, the ‘real’Fed funds rate is more than 2%. During the 1990-91 recession, the real Fed funds rate dropped to -0.55% before rising again to 1%, where it remained for nearly two years. This suggests that the Fed has quite a margin for lowering rates despite the relatively rapid growth in money supply in recent months.

Unfortunately, minutes of the last Federal Open Market Committee (FOMC) meeting suggest that some Fed members have begun to question the need for further easing just at a time when markets need a signal of continued support. Imagine, for example, if mortgage rates could fall and stay below the 7% mark. Imagine also if the Fed could bring some relief to debt service in general, given the high levels of household debt and very low levels of personal savings. Bear in mind that federal and state government spending contributed significantly to second-quarter GDP growth, but in the months ahead the burden will revert almost solely to the consumer. This is no time for analysts to advocate Fed neutrality.

Nor is it time to rejoice at the prospects of consistent growth in aggregate and a concomitant acceleration of business spending. Business fixed investment has always been cyclical, but it appears that this downturn has been different because of the perception that firms may be holding significantly more capital goods than they would prefer. This view suggests that business investment will have to remain subdued for some time before this capital overhang works itself out. Initially, given the apparent concentration of the capital overhang in the high tech sectors, it was believed that rapid obsolescence would trigger a quick resurgence of capital spending. Today such optimism is mitigated by the recognition that some types of high tech capital do not depreciate rapidly, and the acknowledgment that obsolescence is often in the eye of the beholder. For example, optical fibre in the ground does not deteriorate quickly. On another level, cost-conscious companies may decide to stay with existing computer and communications equipment until demand grows or ‘killer apps’ appear. Finally, deregulation in the technology sector combined with the constant appearance of new competitors and a volatile industry structure may be causing potential investors to postpone spending until a clearer view emerges about likely winners and losers and the subsequent evolution of markets.

Monetary policy may be less effective in combating these types of structural issues, but monetary policy operates across a range of channels affecting housing, consumer and business spending, and net exports, and it would be foolish to think that Alan Greenspan and his fellow governors have completed their work.

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