The Economy

Dec. 21, 2004
Year 2000 will hold your interest.

The buzz on the Street recently has been that since the Fed declined to tighten at the December Free Open Market Committee meeting because of possible Y2K glitches, it would make up for lost time by boosting the funds rate 50 basis points at the upcoming Feb. 1-2 meeting. Whether this happens or not, I think the funds rate will rise from 5-1/2% to 6-1/2% during the course of this year. Yet the Fed doesn't raise rates in a vacuum. If the funds rate does indeed rise a full percentage point, that will happen because of increased concerns about higher inflation. For it is becoming clear that inflation does not mean the same thing to everyone. Do we predict inflation according to the Bureau of Labor Statistics (BLS), or according to how much prices are rising and how that affects financial markets? Given the current state of worldwide labor and commodity markets, and even more important, the state of BLS methodology, I am confident that the increase in the published Consumer Price Index (CPI) this year will be no higher than 2.5%. However, in terms of bond market performance and strategy, that figure is becoming increasingly irrelevant. To a large extent, bond holders are people with substantial savings and hence are likely to have above-average income. Thus yields must reflect a rate of inflation commensurate with how fast prices are actually rising, compared with how fast the BLS says they are rising. Last year, nominal GDP rose about 5-1/2%; if this figure is measured from the income side and takes into account the growing statistical discrepancy, the figure is about 6%. Employee-hours rose about 1-1/2% last year, so if real growth rose 4-1/2% and inflation rose 1-1/2%, then by definition productivity rose about 3%. However, suppose that prices actually rose 3% last year, in which case productivity actually increased only about 1-1/2%, which is closer to its long-term average. In that case, bond yields would be much higher than indicated by the current minuscule rate of inflation. Let's do a little arithmetic, and assume measured productivity continues to rise at 2-1/2% per year over the next century. The standard of living in 2100 would be 12 times today's level, so the median family income would rise from an estimated $52,000 in 2000 to $624,000 in constant dollars. The average American would be very wealthy indeed. There is, of course, a gaping hole in this logic; if people really were that wealthy, they would spend a much higher proportion of their income on luxury goods and services, so the CPI as it is currently structured would no longer represent what the average consumer buys. As the proportion of luxury goods and services rises, the CPI will rise faster and productivity growth will diminish, because most of these goods and services have productivity gains close to zero. The price of these items rises about twice as fast as the CPI. Which brings us back to Alan Greenspan, the bond market, and the stock market. Greenspan has been the darling of Wall Street because he has set rates where the gurus of the Street think they ought to be. Paul Volcker, former chairman of the Fed, did the heavy lifting, so Greenspan was not forced to keep rates far above inflation, and except for the aftermath of the S&L crisis he did not keep rates at unrealistically low levels. To retain credibility, though, Greenspan must follow the lead of bond markets. If bond investors are to be properly compensated for the actual increase in prices, the Fed must accede to this sentiment. If it does not, word will circulate that the Fed has thrown in the towel, in which case interest rates will rise even faster. Thus both short- and long-term interest rates will continue to rise this year even if the measured rate of inflation remains flat and the budget surplus continues to increase. Michael K. Evans is president of the Evans Group and professor of economics at the Kellogg School of Business, Northwestern University, Evanston, Ill. His e-mail address is [email protected].

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