Michael Knox | Morgans
In this issue, we look at what the Federal Reserve is attempting to do and the result of its actions. To do this, we use two documents. The first is the Summary of Economic Projections, released by the Federal Reserve on 15th June 2022. The second is the Chicago Fed National Activity Indicator released by the Chicago Fed on 21 June 2022.
The Summary of Economic Projections of 15th June tells us that what the Federal Reserve is attempting to do is to slow the US economy to below trend growth. It estimates that trend growth in the US economy is a GDP growth rate of 1.8%. This growth rate is a combination of the annual growth in the labour force, plus growth in productivity.
Back in the March 2022 meeting, the Fed thought that growth in calendar 2022 would be 2.8%. In June 2022, they thought that actions they had already done, would slow the growth rate in 2022 to 1.7%. Again in March 2022, they thought that growth in calendar 2023 would be 2.2%. In June, they thought that what they had already implemented, would slow growth in 2023 to 1.7%.
What the Fed is attempting to do is slow growth, so that unemployment goes up. In March they thought that unemployment at the end of 2022 would be 3.5%. Now they think it will be 3.7%. Similarly in March they thought that unemployment at the end of 2023 would be 3.5%. They now believe it will be 3.9%. Further, they think that unemployment will rise to 4.1% in 2024.
What the Fed is attempting to do is slow the US economy to below trend growth rate, so that rising unemployment will put downward pressure on inflation. They think that they will be successful in reducing inflation from a 5.2% Personal Consumption Expenditure (PCE Inflation) in 2022 to 2.2% in 2024. Most importantly, they believe that they will achieve this fall in inflation without the US falling into periods of negative GDP growth. This means they believe there will be no US recession.
The question is, how will we know that they are being successful in avoiding recession? We have spoken before about the Chicago Federal Reserve National Activity Index. This is a long established publicly available way of judging whether the US is in recession. This is a broad measure of the US economy. It has 85 different indicators which are updated every month. The scale of the index is in standard errors. When growth is strong enough to generate rising inflation, it is above 0.2 on the scale (0.2 standard errors above trend). When the US economy is growing at long term trend, the index is at a level of zero. This would now be equivalent to a GDP growth rate of 1.8%.
When US GDP is falling, then the National Activity Index is below -0.7. At that point, the US economy is in recession. So, where is the US economy now? The National Activity Index for the US economy in May was released on 21 June 2022. Back in April 2022, the three-month moving average of the National Activity Index stood at 0.48. This means that US growth was still strong enough to be putting upward pressure on inflation. In May, the three-month moving average of the National Activity Index fell to 0.2. This is still above trend growth, but not strong enough to be adding to inflation.
This reading is far above what would indicate a US recession. We can say with great confidence that the US economy is not now in recession. What we believe will occur as the Fed slows the US economy to below trend growth, is that the level of the National Activity Indicator will fall into a range which is below zero but above -0.7. The US economy will slow but avoid recession. Importantly, we can check progress of the Federal Reserve by looking every month at the Chicago Fed National Activity Index. This can be found at www.chicagofed.org.
The path for interest rates?
In order to achieve the Fed’s economic objective, the summary of Economic Projections suggests that Fed Funds rate will rise to 3.4% by the end of 2022. This would suggest a Fed Funds rate band of 3.25% to 3.5%. The effective Fed Funds rate would be just below 3.35%. There is no Fed meeting in either August or October. Meetings are in July, September and the beginning of November. The Fed could achieve this November interest rate of 3.35% with two 50 basis point rate hikes, and one 75 basis point rate hike. The order of these rate hikes of course is entirely up to the Fed to decide.
Were the RBA to match this rate of increase, it would need to have a rate hike of 50 basis points in the June, August, September, October and November meetings. Should it do this, then both the Fed and the RBA would have an official short rate of 3.35% by the end of the first week of November 2022.
We note that such a path of interest rates in each country, would be dependent upon the flow of data coming forward independently to each Central Bank.
The US economy is not now in recession. What we believe will occur as the Fed slows the US economy to below trend growth, is that the level of the National Activity Indicator will fall into a range which is below zero but above -0.7. The US economy will slow but avoid recession. Importantly, we can check progress of the Federal Reserve by looking every month at the Chicago Fed National Activity Index. This can be found at www.chicagofed.org.
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