NEWS / Foreign Exchange

Salient Features of the U.S. Economy Before the Fed Eased in 1995 vs. Now

There are essentially two schools of thought about the next move of the FOMC: (1) a federal funds rate lower than the current level of 5.25% in 2007 and (2) a federal funds rate higher than 5.25% in 2007.

We think a trip back in time to 1995 should help sort out some basic issues. During February 1994 to February 1995, the Fed has raised the federal funds rate 300 basis points to 6.00%. The sharp tightening of monetary policy was followed by the Fed lowering the federal funds rate thrice on July 6, 1995, December 20, 1995, and January 31, 1996, leaving the funds rate at 5.25% at end of the three rate cuts. The FOMC held the funds rate at 5.25% until March 1997. The 1995 easing is often cited as the successful soft-landing episode. It is instructive to examine the similarities and differences between the current business cycle and the 1995 status of the U.S. economy to understand if a similar strategy is appropriate.

The Fed eased on July 6, 1995 when the unemployment rate of June 1995 was 5.6% after a 5.8% reading in April 1995. The jobless rate essentially moved in the narrow range of 5.4% and 5.8% between January 1995 and May 1996.

The Fed has held the federal funds rate at 5.25% since June 2006 after 425 basis points of tightening over a period of two years. The unemployment rate has moved around the possibly cycle low range of 4.4% to 4.6% for seven straight months ending March 2007. The unemployment rate is a lagging indicator which peaks long after the trough of a business cycle.

Nonfarm payroll employment rose 2.7% in June 1995 on a year-to-year basis, after posting a peak reading of a 3.5% year-to-year increase in October 1994. In other words, the Fed eased when nonfarm payrolls showed a decelerating trend.

Nonfarm payrolls grew 1.46% from a year ago in March 2007. The cycle peak appears to have been a 2.14% year-to-year increase in March 2006. Nonfarm payrolls are showing a decelerating trend quite similar to 1995.

The inflation situation is different now to the extent the FOMC was being applauded in 1995 for building on the inflation battle that Chairman Volcker had engineered.

The recent reversal of the trend of core inflation is the cause for the hawkish rhetoric from the Fed. However, the March core consumer price index rose 2.45% on a year-to-year basis, after holding at a 2.7% gain in January and February. The current FOMC??™s comfort zone is year-to-year core inflation readings of below 2.0%.

Real GDP grew at an annual rate of 1.1% and 0.7% in the first and second quarters of 1995.

Real GDP has grown at an average pace of 2.3% in the last three quarters of 2006. The economy is predicted to grow below potential GDP for most of 2007.

There were convincing signals from the factory sector of noticeable slowing conditions in 1995. The ISM manufacturing index held below 50.0 in seven out of eight months starting May 1995. The growth rate of factory production had peaked in January 1995 and the factory sector was growing at a lackluster pace when the Fed eased in July 1995.

The ISM manufacturing composite index moved below 50.0 in November 2006 and January 2007. The March 2007 reading of 50.9 is unimpressive. The growth rate of factory production appears to have peaked in September 2006. Factory production grew 2.3% on a year-to-year basis in first quarter of 2007, which is a considerable deceleration from a 5.7% increase in the third quarter.

The housing sector is at the center of major macroeconomic policy discussions at the present time. Going back to 1995, residential investment expenditures had declined for four straight quarters by mid-1995. Consumer spending grew at an annual rate of 0.6% in the first quarter of 1995 and gather momentum in the subsequent quarters.

Residential investment expenditures have already declined in each of the five quarters ended fourth quarter of 2006. The resilience in consumer spending at present has been supported by large mortgage equity withdrawals, a phenomenon that did not exist in 1995. Going forward, consumer spending is expected to show a sharp deceleration which is already evident in retail sales in the first quarter. Inflation adjusted retail sales grew at an anemic pace of 1.93% in the first quarter of 2007 vs. a 11.7% annualized increase in the fourth quarter.

The spread between the 10-year U.S. Treasury note yield and the federal funds shows that the inversion of the yield curve now more pronounced compared with 1995.

The Index of Leading Economic Indicators (see chart 14) is sending a stronger signal currently about slower economic growth in the months ahead compared to the signal in 1995.

Conclusion ??“ Need we say more? The charts speak for themselves. Moreover, the exposition here excludes the ramifications of the housing market situation in 2007 and the impact of the reduction in mortgage equity withdrawals on consumer spending. Both of these events are germane to the current business cycle only. There was nothing comparable to these developments that prevailed in 1995.

Note: This commentary was inspired by interesting and challenging questions from partners in Northern Trust. Keep asking the questions.