Academic journal article ABA Banking Journal

Will We Get Fooled Again by the Fed?

Academic journal article ABA Banking Journal

Will We Get Fooled Again by the Fed?

Article excerpt

As we look toward the remainder of 1996 and consider what may lie ahead in 1997, once again the banking community is faced with a nagging uncertainty about Federal Reserve policy. The key question is, if the economy continues to slow, how aggressive will the Fed become in lowering interest rates?

It is almost a rule that projections for the federal funds rate will be wrong, and the experience over the past decade has done nothing to change that belief. After peaking at 10% in early 1989, the Fed began a protracted process of easing in order to keep the long expansion of the 1980s alive. In early 1990, forecasts of a 6% funds rate were considered quite aggressive, while a 4% estimate brought only smiles to the forecasting community. Even when the economy slipped into recession in mid-1990, there were few who would venture a guess that the funds rate could drop below 5%. Needless to say, by the fall of 1992, the Fed had given us a 3% funds rate.

Last July, the Fed started a new process of easing in order to ensure the continuation of the current growth phase and once again there are those who believe that rates will not move dramatically. Could we get fooled again? Yes The key concern for the economy is that employment growth has been on a steady decline since late 1994. In 1993, about 2.8 million new jobs were creatd, while in 1994, the pace accelerated to 3.5 million jobs. But only 1.75 million new positions were added in 1995 and it is possible that the rate of job creation will slow further. Payrolls may rise by no more than I million this year. While this may seem like a satisfactory pace, the implications for the national economy are quite negative.

Solid employment growth is essential because of its impact on income and consumer confidence. If monthly payroll gains slip from the nearly 150,000 averaged in 1995 to 85,000 this year, wage and salary gains could be depressed by as much as one percentage point. With consumer demand accounting for two-thirds of the economy, a reduction in income growth of this magnitude could restrain GDP growth by upwards of 0.5 percentage point. The economy grew by only 1.4% between fourth quarter 1994 and fourth quarter 1995, and a growth rate below 1% would not be sustainable. …

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