Reading the economic tea leaves

The Federal Open Markets Committee held the Federal Funds interest rate at 5.25 percent last week. My sense is the economy is slowing down lately, but the Fed continues to issue statements that indicate it is still worried about inflation. Here is what it said after its May 9 meeting:

Economic growth slowed in the first part of this year and the adjustment in the housing sector is ongoing. Nevertheless, the economy seems likely to expand at a moderate pace over coming quarters.

Core inflation remains somewhat elevated. Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures.

In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.

There are people who get paid a lot of money to try to figure out what the Fed means every time it issues a statement like that. One of my favorite Fed watchers is an economist at Louisiana State University named Ed Seifried. I met him two summers ago when I sat in on some economics lectures at the Stonier Graduate School of Banking at Georgetown University.

Seifried was in Lincoln, Nebraska on May 4 to address a business meeting that I participated in. Seifried told the group we have about a one-in-three chance of sinking into recession.

Seifried detailed research that describes the relationship between the yield curve and the probability of recession. He said that the greater the spread between the 10-year bond and the 90-day Treasury bill, the less chance of recession. The likelihood of recession grows, he said, as the spread narrows. The odds of recession grow tremendously when the spread goes negative. With a current negative spread of 25 basis points on May 4, Seifried said, we have a 33 percent chance of entering recession. (Since then, the spread has narrowed to a negative 5 basis point.)

“This is one of the longest inversions I have ever seen,” Seifreid said. “It is rare to have the yield curve inverted for so many months.”

Seifried explained that an annual trade deficit, currently running at about $700 billion per year, is putting a lot of dollars in the hands of foreigners. The flood of American dollars keeps long-term bond rates low. Seifried said that as the American appetite for foreign-made products remains strong, the trade deficit will remain high and bond sellers will have no need to raise interest rates. He said he does not expect long-term bond rates to increase much for a long time.

Short-term rates, he said, will decline. He cited the Taylor Rule, a mathematical equation developed by a Stanford economist in the early 1990s that accurately tracks decision making at the Federal Reserve. Throughout the Greenspan years, the Taylor Rule tracked the Fed Funds rate almost exactly. Seifreid said if you plug the numbers into the formula today, you come out with an interest rate of 5.00 percent, which is 0.25 percent lower than the current Fed Funds rate. He said, therefore, he expected the rate to drop.

“Where do I think rates will be this time next year,” Seifreid asked. “I think interest rates will be as low as 4.00 percent…Short term rates are going to have to come down. The Fed Funds rate will be 4.00 percent within the next 18 to 24 months.”