Neutrality and beyond

Pundits will tell us the course of Fed policy under new chairman Ben Bernanke will be data-dependent. However, we can — and do — anticipate economic data. The U.S. economy has grown by 3 percent or more for 10 of the past 11 quarters, and the dip to 1.1 percent in Q4 2005 is subject to statistically significant upward revisions. More importantly, growth in Q1 2006 is likely to rebound smartly into the 4.5-percent area, if not stronger.

Such growth raises the risk the economy will run out of spare capacity, as the two most recent FOMC statements have warned. Industrial capacity utilization rates were interrupted by the hurricanes, but have since rebounded back above the 80-percent threshold, and slack in the labor market has diminished as the unemployment rate has edged lower to 4.7 percent.

As counterintuitive as it may seem, the actual monthly inflation reports may not be the most critical of all the data potentially influencing the trajectory of Fed policy. Federal Reserve officials, including both the past and current chairman, have indicated a preference for the price deflator of core personal consumption expenditures as a measure of inflation. But this measure clearly trended lower throughout 2005, while the Fed raised the Fed funds target at each of the year’s eight FOMC meetings. This measure of inflation peaked a year ago near 2.3 percent year-over-year, and as of December had slipped to 1.9 percent, matching its lowest level since March 2004.

The point is, the Fed needs to be on guard against the risks of inflation, not actual inflation. Given the trajectory of growth and the suspicion that resource constraints are being approached, there is no compelling reason the Fed has to stop at a neutral stance — and indeed, this has been the message of several Federal Reserve Bank presidents and some members of the FOMC. But even if it does, the guidance from the Fed suggests neutrality to the extent it is a useful concept, represents a range rather than a fixed point, and the upper end of that range extends toward 5.50 percent. The argument that the dollar is still in the second phase of the large cycle is predicated on the idea the market, as it tends to, continues to underestimate the extent and duration of the current tightening cycle.

Meanwhile, the Euribor futures strip has priced in an aggressive ECB — one that could deliver three 25-basis point rate hikes over the course of 2006. In late January through mid-February, ECB officials signaled the market’s assessment was reasonable. Consequently, the widening of the interest-rate differential that has taken place in 2006 has thus far happened largely as a result of a shift in expectations of the trajectory of U.S. interest rates, not European rates. If there is a surprise from the Eurozone, it is the risk the economy will disappoint as it has repeatedly in the past, making fewer rate hikes more likely than more.