U.S. Economic and Interest Rate Outlook
December 13, 2000
The Risk Case Looking More And More Like The Base Case
For several months now, our base-case forecast has been that real economic activity would moderate to a pace just under the perceived potential growth rate of the economy. This more moderate growth would serve to relieve the inflationary pressures that are building in the economy. All of this was forecast to occur with no change in the Fed's interest rate policy. And up until a few days ago, this still was our base-case forecast.
Now, however, we are torn between this base case and our risk case - that economic growth comes in even weaker than expected. In our view, evidence has mounted in recent weeks, indeed, in recent days, that economic growth in the first half of next year will be significantly below potential, which, in turn, will prompt the Fed to cut its funds rate target by 50 basis points - perhaps by the end of the first quarter. Because, however, some of the first-half weakness could be weather-related, the combination of warmer third quarter temperatures and first-quarter Fed easing would be expected to promote a second-half economic rebound. We also believe that inflationary pressures in the service sector will rebuild in the second half of next year to the degree that the Fed might be faced with a tightening decision toward the end of 2001.
Let's begin by discussing why we believe that the former base-case forecast still has some validity. It boils down to money supply growth and a particular yield spread. Although it is not fashionable anymore to look to the behavior of monetary aggregates for guidance as to what future economic growth will be, we continue to believe that growth in the "real" M2 money supply is one of the best leading indicators around. It was what led us to believe in the spring of this year that second-half economic growth would moderate. As Chart 1 below shows, year-over-year real M2 growth typically approaches zero prior to the onset of a recession (the shaded areas). But, as also is shown in Chart 1, the recent descent in real M2 growth has been halted well above the point at which it has historically heralded a recession. So, the current behavior of real M2 is not suggesting Greenspan's cavalry needs to come to the rescue of an economy entering a cumulative decline.
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Regards,
JM |
