The Northern Trust Company Economic Research Department U.S. Economic and Interest Rate Outlook 50 South LaSalle Street, Chicago, Illinois 60675

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The Northern Trust Company Economic Research Department U.S. Economic and Interest Rate Outlook 50 South LaSalle Street, Chicago, Illinois 60675 http://www.northerntrust.

1 The Northern Trust Company Economic Research Department U.S. Economic and Interest Rate Outlook 50 South LaSalle Street, Chicago, Illinois (See Economic Research) Paul Kasriel (312) Fax (312) April 12, 2004 This (1%) Will Not Stand After much soul and data searching, this is what we have concluded that a 1% federal funds rate will not stand in the second half of this year. We started the year believing that the Federal Open Market Committee (FOMC) would begin raising the fed funds rate at its August 2004 meeting with a 25 basis point hike, and follow up with 25 basis point increases at each of the three remaining 2004 FOMC meetings. Then, in February, we called off any funds rate hikes for the year based on our below-consensus economic growth forecast, the market s apparent lack of concern about inflationary pressures, and dovish Fed rhetoric. Acknowledging that we are open to the criticism of flip-flopping, this month we have decided to split the difference a 50 basis point hike at the August FOMC meeting and then no more fed funds rate increases until early There are three reasons for our changed view. Firstly, the employment environment appears to be improving. Secondly, so-called core inflation appears to have bottomed. Thirdly, inflation expectations appear to be rising. With regard to our economic forecast, not much has changed. Our 2004 real GDP forecast remains the same 3.8% Q4/Q4 vs. the Blue Chip consensus forecast of 4.2%. Our 2004 CPI inflation forecast has been bumped up a tick to % Q4/Q4 vs. the Blue Chip consensus forecast of 2.1%. In Fed parlance, we think the risks to our real GDP forecast are evenly balanced, while the risk to our inflation forecast is tilted to the upside. Did the March employment report, which showed an increase in nonfarm payrolls of 308,000, with upward revisions to January and February payrolls of 62,000 and 25,000, respectively, cause us to change our Fed forecast? In all candor, yes, but not for the obvious reasons. We place little weight on the monthly employment survey statistics, be they from the Establishment survey (nonfarm payrolls) or the Household survey. There are just too many assumptions that go from the sample to the population estimate to suit us. No, we prefer the report that counts real people standing in real unemployment insurance benefit lines in order to gauge the condition of the labor market. But we are even cautious about looking at the state unemployment data on a seasonallyadjusted basis, especially with weekly data. So, we like to look at the trend in year-over-year percent changes in unemployment insurance claims. Chart 1 shows a pronounced downward trend in both new claimants and veteran claimants. We are not saying that the labor market has improved to the extent that a June college graduate with a degree in economics could get a job. But we do believe that the labor environment is improving and will continue to do so in the foreseeable future.

2 2 Chart 1 < Unemployment Insurance: Initial Claims, State Programs % Change - Year to Year NSA, Thous Insured Unemployment, State Programs > % Change - Year to Year NSA, Thous Source: Department of Labor /Haver Analytics -40 These downward trends in initial and continuing unemployment claims had been in place before the release of the March employment report. So, why did our Fed policy forecast change with the stronger-than-expected monthly employment report? Although we may not place much weight on the monthly employment reports, the Fed does. And the Fed has cited a lack of meaningful improvement in the labor market as the principal reason for its patience with respect to a 1% funds rate. Although we do not expect another 300K+ monthly increase in nonfarm payrolls between now and August, we do expect strong enough average monthly increases between now and August to cause the Fed to lose some of its patience. Another factor that is likely to cause the Fed to have lost patience with a 1% funds rate by early August is inflation. The Fed s favorite measure of inflation which just happens to be one of the lowest of the conventional measures is the year-over-year percent change in the chain-price index of Personal Consumption Expenditures (PCE), excluding those pesky food and energy price components, of course. Some FOMC members had been forecasting a further slowdown in this inflation measure even as the economy picked up speed. Alas, another beautiful theory ruined by some ugly facts. As shown in Chart 2, core PCE inflation bottomed out at 0.8% in December of last year, and has since moved up slightly above 1%. Not hyperinflation, to be sure. But moving in the direction to try the patience of some FOMC members, not to mention fixed-income investors.

3 3 Chart 2 PCE less Food & Energy: Chain Price Index % Change - Year to Year SA, 2000= Source: Bureau of Economic Analysis /Haver Analytics 0.8 Where have all the bond market vigilantes gone? To Treasury-Inflation-Protected securities (TIPS). Starting early in the fourth quarter of last year, the yield on TIPS started falling (see Chart 3) as fixed-income investors sought inflation protection, perhaps because Fed officials were talking and acting as though they wanted to generate higher inflation about the only thing the Fed is capable of doing. (Is the Fed akin to an arsonist on the fire department?) Nominal 10-year Treasury yields fell, too, but to a lesser extent than TIPS yields. The difference between the yields on these two types of Treasury securities is a proxy for the market s expectations of CPI inflation. After bottoming out at about 160 basis points in early June of 20, this yield spread has widened out to about 240 basis points of late (see Chart 3). We expect market expectations of inflation to increase in the months between now and August. In order for the Fed to regain the mantle of inflation fighter, it will have to engage in open market operations, not just open mouth operations.

4 4 Chart 3 < CPI Inflation Expectations: 10-Yr. Nominal Treas. Yld. - 10Yr. TIPS Yld. % Year Treasury Inflation Indexed Note Yield at Constant Maturity > Avg, %p.a Why 50 basis points in one fell swoop in August? We should let Steve East, a bright economist at Friedman Billings Ramsey, answer this because he was the person that put this idea in our heads. As Mr. East argues, the Fed does not want market participants to think that the FOMC s behavior in 2004 and into 2005 will be a rerun of its behavior in That is, the Fed does not want the market to think that every FOMC meeting going forward from August 2004 will be accompanied by a fed funds rate hike. By moving 50 basis points at one time and with the proper Fedspeak, the FOMC can convey the notion that the need for an emergency funds rate level is past, but the need for further near-term rate hikes is not yet upon us. This puts the FOMC on the sidelines during the height of the election campaign season. At the same time, having raised rates by more than a token amount prior to November 2, the Fed cannot be accused of being the Bush administration s handmaiden. By moving 50 basis points at one time, presumably some daylight can be put between the nominal fed funds rate and the core PCE inflation rate again reinforcing the notion that a negative real fed funds rate is no longer necessary. Paul L. Kasriel, Director of Economic Research (plk1@ntrs.com) Asha G. Bangalore, Economist (agb3@ntrs.com)

5 5 THE NORTHERN TRUST COMPANY ECONOMIC RESEARCH DEPARTMENT April 2004 SELECTED BUSINESS INDICATORS Table 1 US GDP, Inflation, and Unemployment Rate :1a :2a :3a :4a 04:1f 04:2f 04:3f 04:4f 02002a 20a 2004f 2002a 20a 2004f REAL GROSS DOMESTIC PRODUCT (% change from prior quarter ) Q4/Q4 change annual change CONSUMPTION EXPENDITURES BUSINESS INVESTMENT RESIDENTIAL INVESTMENT CHANGE IN INVENTORIES ('96 dlrs, bill) * -0.7* 35.4* GOVERNMENT NET EXPORTS (Cha.'96 dlrs, bill.) * * * FINAL SALES NOMINAL GROSS DOMESTIC PRODUCT GDP DEFLATOR - IMPLICIT (% change) CPI (% Change, = 100) CIVILIAN UNEMPLOYMENT RATE (avg.) * 6.0* 5.5* a=actual f=forecast *=annual average Table 2 Outlook for Interest Rates Quarterly Average Annual Average SPECIFIC INTEREST RATES :1a :2a :3a :4a 04:1a 04:2f 04:3f 04:4f 2002a 20a 2004f Bank Prime Federal Funds mo Neg. CD (Sec. Mkt) mo.LIBOR mo. Treasury Bill (discount basis) 2-yr. Treasury Note yr. Treasury Note yr. Treasury Note Moody's AAA Corporate Bond Buyer Index a = actual f = forecast

The Worst Recession since the Great Depression? Perhaps, But December 15, 2008

The Worst Recession since the Great Depression? Perhaps, But December 15, 2008 Northern Trust Global Economic Research South LaSalle Chicago, Illinois 663 northerntrust.com Paul L. Kasriel Director of Economic Research 312..1 312.7.267 fax plk1@ntrs.com Asha Bangalore Economist 312..16