Ever wondered why so many economists and financial analysts have been so wrong during the past three years forecasting the economy, inflation and the direction of interest rates?
How many times have we read that lower interest rates and an accommodative Federal Reserve Board monetary policy will stimulate the economy, increase economic growth, which in turn will rekindle inflation and eventually led to higher interest rates. Many of Wall Street's star prognosticators have stumbled with their recent predictions based on that type of a business cycle scenario.
In a very simplified overview, during previous post-World War II business cycles, we have experienced economic downturns caused by the Fed restricting the growth of the money supply in an effort to slow the economy and curtail inflation. As the economy sags and inflation drops, the Fed would then loosen its grip on the money supply, allowing interest rates to fall, which in turn stimulated economic growth. As the economy approached full operating capacity, excess demand occurred, which led to increases in the cost of labor and commodities and, eventually, in the finished product. In other words, the inflation cycle would be in operation. This inflation process would continue until the Fed would once again induce a recession, and then the entire business cycle would repeat itself.
One person who has been accurate in his forecast is Prudential-Bache's chief economist, Ed Yardeni. Perhaps the main reason for his accuracy is that he has looked at the recent business cycle and has noted that two of the components that have given rise to inflation in the past are missing. These are labor costs, but, more important in Yardeni's concept, commodity prices. He reasons that, during the 1970s when shortages of products and commodities arose, "productive capacity expanded as speculators poured billions of dollars of other people's money into inflation bets hoping to win big by exploiting the shortages." Overproduction resulted, and "the shortages of the 1970s evolved into the gluts of the 1980s." Also, as we entered the 1980s, the Fed embarked on the process of "breaking" inflation, which, in time, they did.
"Demand for commodities and products flattened as deflationary pressures reduced the spending power of inflation's beneficiaries; namely, the Arabs and Latins," he said. This led to too much global capacity. "Too many goods are chasing too few consumers," he said. Since the 1981-1982 recession, we have been on a deflationary path. Even lower interest rates have done little to stop that plunge in commodity prices.
Because of the severe recession of 1981-1982, the deregulation of the transportation sector and an "international market or pool of labor," labor costs have either fallen or have shown only modest increases since the recession. Or, as Yardeni notes, "There's a glut of labor" as well. To date, the Fed's easier monetary policy and lower interest rates have done little to spur the economy forward. At the same time, inflation has continued to decline due mainly to the "gluts." It therefore would appear that the Fed could afford to release its stranglehold on the money supply in an effort to reduce interest rates even more. Because of the economic sluggishness, Yardeni said he believes interest rates must go much lower, not only to stimulate the economy, but "to avoid a deflationary depression." With this idea in mind and with certain sectors of the business cycle acting differently, Yardeni changed his interest rate forecast. He sees the yield on the long T-bond falling to 6 percent by midyear, accompanied buy two more cuts in the discount rate. Perhaps his novel approach to the business cycle will prove correct once again. And, if he is correct, there still are significant gains to be made in the long maturities of the bond market.