Friday, August 12, 2005

WSJ Monthly Economic Forecasting Survey: August 2005

Where exactly will the federal-funds rate end up when the Fed is done with its credit-tightening campaign?

The answer, according to economists surveyed this month, is 4.5%, a full point above its current level. Economists say they believe there is a greater risk that the Fed will overshoot -- lift rates too high -- than it will move too gingerly.

Economists lifted their forecasts for third-quarter gross domestic product growth to 4.2%, well above the 3.5% that they predicted when surveyed in June. They cut their forecasts for the jobless rate for the first time this year.

Economists believe the yuan's value will rise to 7.86 yuan per dollar in the next year, up from about 8.11 yuan now. They expect the U.S. trade deficit with China to continue to expand through 2006.


Knowing When to Say 'When'

Economists Expect Rates to Reach 4.5%,But Will the Fed 'Overshoot' Its Target?


The Federal Reserve has been moving interest rates higher for more than a year. Will it know when to quit?

By a narrow margin, economists surveyed in the latest Wall Street Journal Online forecasting survey say they think there's a greater risk the Fed will go too far in its campaign of rate increases than it will stop short of what's needed. About 54% said they see a greater risk of the Fed moving too aggressively in the next year, while 46% say the bigger concern is rates will be kept too low.

The Fed is expected to continue to move interest rates higher until the federal-funds rate, a key short-term rate that helps determine rates throughout the economy, reaches 4.5%, based on the median estimate of the 56 economists who were surveyed Aug. 5-9. Earlier this week, the Fed lifted the fed-funds rate by a quarter percentage point to 3.5%, the 10th such increase since last June.

On average, the economists expect the funds rate to be 4% by the end of 2005 and 4.25% by mid-2006. But some think that the Fed will go further -- and faster. Economists at Goldman Sachs, for example, believe the central bank will bring the funds rate all the way to 5% by the middle of next year.

Ethan Harris of Lehman Brothers Inc. worries that the Fed will overshoot, but he says that the problem is the central bank won't know if it has gone too far until it sees subsequent economic data. "There's a danger that the Fed will keep pushing the brakes until they finally work," Mr. Harris says.

But Peter Hooper of Deutsche Bank Securities Inc. says the lag time between when rates rise and the economy responds could just as easily cut the other way. He's concerned that the Fed will move cautiously and stop too soon.

The Fed began its drive to lift rates a year ago, when short-term rates were at a 46-year low of 1%. The Fed had kept rates low to revive the economy and stave off deflationary pressures. But the economy now has been on a steady growth track for more than a year and a sharp rise in energy prices has engendered fears that inflation pressures will emerge elsewhere in the economy.

Renewed Growth

Although growth pulled back slightly in the second quarter, economists expect the economy to rebound over the balance of the year. Gross domestic product, the broadest measure of economic activity, grew at a 3.4% annual rate in the second quarter, down from a 3.8% rate in the first quarter of the year. Some companies turned cautious in the period and pared inventories instead of producing new goods.

Now, companies are expected to rebuild their stockpiles. In the latest survey, economists lifted their forecasts for third-quarter GDP to 4.2%, well above the 3.5% rate that they forecast in a Wall Street Journal survey conducted in June. The economists expect growth at a 3.6% rate in the fourth quarter, better than the 3.4% they forecast back in June. The economists made little change to their forecasts for early next year, when they expect growth at about a 3.25% rate.

Economists think inflation will remain relatively subdued down the road -- they expect the consumer-price index to be up 2.8% in November and 2.5% in May 2006, the same forecast they issued in June.

While the Fed has been lifting short-term borrowing costs, longer-term interest rates, as measured by bond-market yields, have remained stubbornly low -- a development that Fed chairman Alan Greenspan famously described as a "conundrum." The problem is particularly vexing for what it might say about future economic conditions: as the spread between short- and long-term interest rates narrows, the prospect of an inverted yield curve – a phenomenon associated with recession -- grows.

But few of the economists surveyed say economic weakness is responsible for the lack of movement in long-term rates. About 43% of the economists say the main reason long-term interest rates have stayed low is because inflation is expected to remain low. A number of others say that foreign central bank demand for U.S. debt, or an excess of saving in the global economy, has tamped down long-term bond yields.

"It was difficult to see what would cause the economy to perform as weakly as long term yields would suggest," said Mr. Hooper. "It just didn't make sense in terms of the economic fundamentals."

Still, the economists don't expect the yield on the 10-year Treasury note to increase by much. They predict, on average, that the yield will reach 4.67% by the end of this year and climb to 4.90% by next summer. The 10-year note finished trading Wednesday at 4.398%.

The Yuan and the Trade Gap

Last month, the People's Bank of China said that it would no longer fix the value of the yuan at about 8.28 yuan to the dollar, opting to raise the yuan's value by about 2% to 8.11 yuan to the dollar and to allow the currency to float 0.3% in either direction each day. The Bush administration has pressured China to allow its currency to appreciate in value, amid concerns that the yuan's level against the dollar has contributed to the U.S.'s massive trade gap with China.

The economists expect, on average, that the yuan will appreciate further over the coming year, moving to 7.86 yuan to the dollar over the next 12 months. However, the yuan would need to strengthen a great deal more to reverse China's giant bilateral trade surplus with the U.S. Indeed, the economists believe the U.S. trade gap with China will rise to $175 billion in 2005 and $181 billion in 2006. The U.S. deficit with China was $162 billion in 2004.

In a Wall Street Journal Online survey conducted in May, nearly half of economists said the yuan's value would have to rise by 30% or more -- while a quarter said the yuan would have to rise by between 20% and 29% -- in order to have a meaningful impact on the U.S. trade gap with China.

Succeeding Greenspan

Economists were divided on the question of whom they would prefer succeed Mr. Greenspan, who is expected to retire from the Fed early next year. Ben Bernanke, a former Fed governor and current chairman of President Bush's Council of Economic Advisors, drew the support of 30% of the economists, while Martin Feldstein, president of the National Bureau of Economic Research, and Fed governor Donald Kohn each received the backing of 15% of the group. Former White House economic advisor and Columbia University professor Glenn Hubbard and Clinton administration Treasury Secretary Robert Rubin each were selected by 11% of the group.
President Bush is likely to announce his choice sometime this fall.

Lehman's Mr. Harris thinks that financial markets have become overly complacent about the succession question. He says any successor, no matter how sound, will be selected at some cost to the markets.

"Nobody can replace Greenspan's reputation," Mr. Harris says. "His reputation helps keep low risk premiums in the markets. That will be lost on the day he retires. It can be re-earned by the next chairman, but there will be some loss."

Among other findings in the survey:• Looking overseas, half of the economists say that the European Central Bank should leave interest rates in the euro zone unchanged through the end of the year. The ECB has been under pressure lately to cut rates, but elected earlier this month to stand pat amid signs of strengthening in the euro-zone economy. But there is still pressure for the ECB to cut rates -- 35% of the economists think the ECB should cut rates immediately, while 15% believe a rate cut should come before year end. • The economists raised their forecast for growth in nonfarm payroll hiring over the next 12 months slightly, to 186,000 jobs. Employers added 207,000 jobs to payrolls in July and monthly gains have averaged 191,000 jobs so far this year. The unemployment rate, currently at 5%, is now predicted to be 4.9% in November and 4.8% by May 2006. Economists cut their forecasts for the jobless rate for the first time this year.

FULL RESULTS, PLUS CHARTS : See and download forecasts for GDP, inflation, employment and interest rates. Plus, the economists views on revaluing the yuan, Greenspan's successor, European rates and the federal budget gap. Survey conducted Aug. 5-9.

Download the data from this survey. Survey conducted August 5-9


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