Worries About Low Inflation Will Rule Out a Cut Next Week, Experts Say
After a year and a half of a disappointing recovery from the 2001 recession, U.S. economic growth has finally begun to strengthen in a sustainable way, according to many economists and policymakers. As a result, Federal Reserve officials, who cut interest rates 13 times to fight the slump, aren't going to slash rates again when they meet next week, analysts and investors widely agree.
At the same time, the officials have signaled strongly that in contrast to previous upturns, strong growth won't trigger rate increases for a long time to come. The key reason for this change is that Fed Chairman Alan Greenspan and his colleagues remain concerned that inflation, which has been running around only 1 percent a year, could fall further despite the return of rapid growth.
That concern was underscored yesterday by a report from the Labor Department that productivity, the amount of goods and services produced for each hour worked, shot up at a 5.7 percent annual rate in the second quarter in the non-farm business portion of the economy. Even though workers' pay and benefit costs were going up, such a hefty productivity gain meant that businesses' labor costs were falling, giving them much more leeway to cut the prices of the goods and services they sell to remain competitive in today's global economy.
"This is an extraordinary performance," said Martin Baily of the Institute for International Economics. "The acceleration of productivity that started after 1995 is continuing. It was not just a cyclical phenomenon, the result of the strong business expansion. It is being driven by intense competitive and profit pressures."
Some analysts think it could be the middle of next year before the Fed begins to raise rates. Others, including economist Bill Dudley at Goldman Sachs Group Inc., think inflation will slow further and short-term rates could remain where they are until mid-2005, or perhaps be cut again first.
With plenty of slack in U.S. labor and product markets and competitive pressures intense, Fed officials are concerned that inflation could continue to drift downward from its already very low level. The closer to zero that inflation falls, the greater the danger that a shock of some sort -- such as another devastating terrorist attack in the United States -- could put the economy and prices into a tailspin. A broad decline in the level of prices, known as a deflation, could do significant damage to the economy and greatly reduce the Fed's ability to use monetary policy to give it a boost. In contrast, a decline in the rate of inflation, which has occurred in the United States over the past two years, is known as disinflation.
"There appears to be some possibility that the recent trend toward disinflation will continue, primarily because of the potentially large amount of economic slack in the system," Fed Governor Ben S. Bernanke said in a speech late last month.
And because Fed officials see the risk of further declines in inflation as outweighing the dangers of a surge in inflation, they will probably keep short-term rates low "for a considerable period," he said.
The Fed lowered its current target for overnight interest rates to 1 percent from 1.25 percent at its June policymaking meeting. Keeping it at that level, "may be sufficient," Bernanke said. "Alternatively . . . we could certainly cut the rate from where it is now. In my view . . . we should be willing to cut the [overnight] rate to zero, should that prove necessary to provide the required support to the economy."
With the economic outlook improving, however, few if any Fed officials are considering pushing for another rate cut -- though some favored a half-percentage-point cut at the last meeting rather than the quarter-point that was agreed to. That more cautious step disappointed many financial market participants, a disappointment that has been a significant factor in the rapid rise in long-term interest rates, including mortgage rates, since then.
While the pickup in growth from the second quarter's 2.4 percent annual rate is still more of a forecast than a reality, as John Lipsky, chief economist at J.P. Morgan Securities, told his firm's clients this week, "Consensus views about U.S. growth prospects are turning upbeat. The Fed's 2003 forecast of 4 percent to 5 percent . . . gains soon will become the conventional wisdom."
Some other forecasters are a bit more cautious, talking about growth in the 3.5 to 4 percent range, rather than 4 percent or above. And some wonder what will happen if productivity gains continue to outstrip expectations, as they did by far in the April-June period. If so, the economy might have to grow at faster than a 4 percent annual rate before the unemployment rate would come down meaningfully.
The arithmetic runs like this:
Suppose productivity were to increase at a 3 percent annual rate between now and the end of next year, instead of the 2 or 2.25 percent rate some analysts believe is now the long-term trend. Add that 3 percent productivity gain to the roughly 1 percent annual increase in the working-age population, and 4 percent economic growth would mean the current 6.2 percent unemployment rate would be little changed at the end of next year.
"That certainly is the risk," said economist M. Cary Leahey of Deutsche Bank in New York. Non-farm productivity gains usually accelerate when economic growth accelerates, and the length of the average workweek is at a historic low, and that could rise, he said.
And some analysts see a possibility that the recovery could stall again if the jobless rate fails to improve. "That's the number one risk we see," Leahey said, though that is not the outcome Deutsche Bank economists expect.
In the productivity report, Labor said that firms in the non-farm sector were able to boost output at a 3.4 percent annual rate in the second quarter while cutting the number of hours their employees worked at a 2.2 percent annual rate.
With production up and hours worked down, productivity rose so rapidly that businesses were able to increase their workers' pay and benefits at a 3.5 percent annual rate while seeing the labor costs per unit of production actually fall at a 2.1 percent rate.
After a year and a half of a disappointing recovery from the 2001 recession, U.S. economic growth has finally begun to strengthen in a sustainable way, according to many economists and policymakers. As a result, Federal Reserve officials, who cut interest rates 13 times to fight the slump, aren't going to slash rates again when they meet next week, analysts and investors widely agree.
At the same time, the officials have signaled strongly that in contrast to previous upturns, strong growth won't trigger rate increases for a long time to come. The key reason for this change is that Fed Chairman Alan Greenspan and his colleagues remain concerned that inflation, which has been running around only 1 percent a year, could fall further despite the return of rapid growth.
That concern was underscored yesterday by a report from the Labor Department that productivity, the amount of goods and services produced for each hour worked, shot up at a 5.7 percent annual rate in the second quarter in the non-farm business portion of the economy. Even though workers' pay and benefit costs were going up, such a hefty productivity gain meant that businesses' labor costs were falling, giving them much more leeway to cut the prices of the goods and services they sell to remain competitive in today's global economy.
"This is an extraordinary performance," said Martin Baily of the Institute for International Economics. "The acceleration of productivity that started after 1995 is continuing. It was not just a cyclical phenomenon, the result of the strong business expansion. It is being driven by intense competitive and profit pressures."
Some analysts think it could be the middle of next year before the Fed begins to raise rates. Others, including economist Bill Dudley at Goldman Sachs Group Inc., think inflation will slow further and short-term rates could remain where they are until mid-2005, or perhaps be cut again first.
With plenty of slack in U.S. labor and product markets and competitive pressures intense, Fed officials are concerned that inflation could continue to drift downward from its already very low level. The closer to zero that inflation falls, the greater the danger that a shock of some sort -- such as another devastating terrorist attack in the United States -- could put the economy and prices into a tailspin. A broad decline in the level of prices, known as a deflation, could do significant damage to the economy and greatly reduce the Fed's ability to use monetary policy to give it a boost. In contrast, a decline in the rate of inflation, which has occurred in the United States over the past two years, is known as disinflation.
"There appears to be some possibility that the recent trend toward disinflation will continue, primarily because of the potentially large amount of economic slack in the system," Fed Governor Ben S. Bernanke said in a speech late last month.
And because Fed officials see the risk of further declines in inflation as outweighing the dangers of a surge in inflation, they will probably keep short-term rates low "for a considerable period," he said.
The Fed lowered its current target for overnight interest rates to 1 percent from 1.25 percent at its June policymaking meeting. Keeping it at that level, "may be sufficient," Bernanke said. "Alternatively . . . we could certainly cut the rate from where it is now. In my view . . . we should be willing to cut the [overnight] rate to zero, should that prove necessary to provide the required support to the economy."
With the economic outlook improving, however, few if any Fed officials are considering pushing for another rate cut -- though some favored a half-percentage-point cut at the last meeting rather than the quarter-point that was agreed to. That more cautious step disappointed many financial market participants, a disappointment that has been a significant factor in the rapid rise in long-term interest rates, including mortgage rates, since then.
While the pickup in growth from the second quarter's 2.4 percent annual rate is still more of a forecast than a reality, as John Lipsky, chief economist at J.P. Morgan Securities, told his firm's clients this week, "Consensus views about U.S. growth prospects are turning upbeat. The Fed's 2003 forecast of 4 percent to 5 percent . . . gains soon will become the conventional wisdom."
Some other forecasters are a bit more cautious, talking about growth in the 3.5 to 4 percent range, rather than 4 percent or above. And some wonder what will happen if productivity gains continue to outstrip expectations, as they did by far in the April-June period. If so, the economy might have to grow at faster than a 4 percent annual rate before the unemployment rate would come down meaningfully.
The arithmetic runs like this:
Suppose productivity were to increase at a 3 percent annual rate between now and the end of next year, instead of the 2 or 2.25 percent rate some analysts believe is now the long-term trend. Add that 3 percent productivity gain to the roughly 1 percent annual increase in the working-age population, and 4 percent economic growth would mean the current 6.2 percent unemployment rate would be little changed at the end of next year.
"That certainly is the risk," said economist M. Cary Leahey of Deutsche Bank in New York. Non-farm productivity gains usually accelerate when economic growth accelerates, and the length of the average workweek is at a historic low, and that could rise, he said.
And some analysts see a possibility that the recovery could stall again if the jobless rate fails to improve. "That's the number one risk we see," Leahey said, though that is not the outcome Deutsche Bank economists expect.
In the productivity report, Labor said that firms in the non-farm sector were able to boost output at a 3.4 percent annual rate in the second quarter while cutting the number of hours their employees worked at a 2.2 percent annual rate.
With production up and hours worked down, productivity rose so rapidly that businesses were able to increase their workers' pay and benefits at a 3.5 percent annual rate while seeing the labor costs per unit of production actually fall at a 2.1 percent rate.
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