Comment 23: Is a recession looming? 1. Gauging the effectiveness of FED tightening. (Sept. 1, 2005)

Recently the talk of a looming recession has suddenly become a hot topic among financial circles. Many analysts proclaim that an economic recession will arrive within 12 months in America. One of the major reasons for the anticipation of an oncoming recession is the persistent rise of short-term interest rate, called the Federal Fund's rate, in the hands of The Federal Reserve Board (abbreviated as FED). Analysts will say that six out of eight most recent recessions started within two years from the date that FED started to raise The Federal Fund's rate. This time FED is raising The Federal Fund's rate for more than a year, thus a recession within the next 12 months should be expected. However, we must note that many so-called rules in economics are not like solid laws in physics and theorems in mathematics that apply universally when the conditions are met. Those economic rules are often loose economic observations the validity of them should be constantly checked against the actual data. The anticipation that the economic performance is synchronized with The Federal Fund's rate is such a loose observation. There are plenty of counter examples to the anticipation. The most famous one is probably the "super low to zero interest rate policy" of Japanese Central Bank. That policy has been in place since 1995 but has failed to invigorate Japanese economy and stop the Japanese deflation. Rather there is strong indication (see Article 1) that it is this "super low to zero interest rate" policy that has turned saving enthusiastic Japanese consumers into super frugal buyers and the policy is really the main cause of the decade long Japanese stagnation and deflation; after all if there is no interest paid on their savings, math savvy Japanese consumers have figured out correctly that they need to save much more to take care of their living after the retirement! As for The United States of America, the observation that six out of most recent eight recessions have started within two years after the tightening by FED is certainly correct, but to conclude that a recession is looming because FED has started to tighten since June of 2004 is a false logic. This is because that the six recessions cited in the observation are the ones preceding the globalization scheme and the two exceptions are exactly two most recent recessions that have occurred after the onset of the globalization scheme at the early 1980's. The coming recession, if it will really come, will rather follow the pattern of the two most recent ones, not the six recessions that occurred before the globalization scheme. The purpose of this comment is to make a thorough analysis based on actual data in order to gauge the effectiveness of FED tightening in the current globalization scheme. This analysis will show that the globalization scheme has changed the structure of economy enormously and has rendered the FED's monetary operation rather ineffective in slowing the galloping economic expansion.

Various quarterly data are plotted in the first figure at the right, ranging from the year 1955 to the year 1990. The black dots are the values of real gross domestic production (abbreviated as Real GDP), obtained from the website of The Bureau of Economic Analysis (, plotted in logarithmic ( log10) scale. The word "real" in front of a data means that the data is adjusted for inflation. The "real" data used here are based on the price index of year 2000 taken as 100. In a logarithmic scale a straight line, for example, an upwardly inclined line, indicates that the data is growing or declining with a constant rate. Thus looking at a logarithmically scaled data set of Real GDP as in the figure, it is very easy to spot a period of economic slowdown. We do not need the artificial definition of a recession as two consecutive quarters of contracting Real GDP; according to this artificial definition of a recession, the most recent painful period of economic slowdown after the burst of the stock market bubble in 2000 does not qualify as a recession! The major turning periods in the growth of Real GDP are labeled in the figure by black numbers ranging from "1" to "7". The label "3" does not correspond to a recession, but the labels 1, 2, 4, 5, 6 and 7 are six recessions prior to the globalization scheme as mentioned in the previous paragraph.

The green dots near the bottom of the figure are quarterly average of The Federal Fund's rates. This is plotted with upside down scale so that higher interest rate can correspond to slower growth or negative growth of Real GDP. The Federal Fund's rate is the interest rate charged on the overnight borrowing among banks, and is the very short-term interest rate that FED can directly control by injecting or withdrawing money from that market. The green numbers 1 to 7 marks the beginnings of major FED tightening. For six labels 1, 2, 4, 5, 6 and 7, within 2 years of each corresponding tightening recessions 1, 2, 4, 5, 6 and 7 had occurred respectively as mentioned in the first paragraph. Only the FED tightening of label "3" did not generate a recession within the 2 year period. The break in the growth rate of Real GDP as marked "3" in the Real GDP data came 5 years after the green label "3". We do not believe that the phenomenon of black "3" is related to the increase of interest rate at green label "3". The yellow dots at the bottom of the figure are the yield difference between 10 year treasury note and The Federal Fund's rate. When this yield difference becomes negative, many analysts believe that a recession will follow. A close inspection reveals that the ups and downs of yellow dots are closely synchronized with the ups and downs of the green dots, the Federal Fund's rate. Thus the yield difference does not provide any more new information than The Federal Fund's rate.

Real money supply M1 is plotted in logarithmic scale as blue dots, and real money supply M3 as red dots. M1 is a narrow measure of money supply that consists of the currency in circulation, the reserves that banks must keep against their deposits, the amount of money in checking accounts and the amount in other checking-like accounts. M1 is well synchronized with The Federal Fund's rate. The broader money supply M3 is closer to Real GDP. In a broader sense M3 rises with a constant rate for quite a few decades, interrupted by dips that correspond to the dips in M1. The ebbs and flows of M3 during this period are well correlated to those of Real GDP. It should be noted that at the end of this period, around label "7", the correlation between M3 and Real GDP is lost, but the correlation between M1 and Real GDP is preserved. Only exception in the correlation between The Federal Fund's rate and the money supply is the period labeled as green "3". During the 5 year period of FED tightening labeled as green "3", M1 failed to contract and Real GDP continued its impressive rise. Through this pre-globalization era we may say that in general FED was capable of periodically slowing down the growth in Real GDP by raising The Federal Fund's rate for a prolonged time interval.

In the next figure similar data are plotted for the time period from 1975 to 2005. The period from 1975 to 1990 overlaps with the previous figure to give a sense of continuity in those data sets. Two recessions, labeled by black "8" and "9", are added. During the period from 1980 to 2005, the synchronization between The Federal fund's rate, the green dots, and the yield difference, the yellow dots, is still holding, and so is the correlation between The Federal Fund's rate and M1 money supply. However, the important correlation between M1 and M3 and the final correlation between Real GDP and The Federal Fund's rate are vastly reduced. Let us go through this break down of correlations in more detail.

As The Federal Fund's rate increased sharply in 1980, at the green label 7, M1 made a timid response, but M3 lacked any response. Real GDP did dip and creating the recession labeled as black 7 in 1981 and is counted as the sixth recession that occurred within two years of FED tightening. The FED tightening of green label 7' created a slow down in the growth rate of M1, but failed to depress the growth rate of M3 at all. We may want to associate the change of the growth rate of Real GDP at the black mark of 7' with the tightening at green 7', but the subsequent loosening of The Federal Fund's rate until the green mark of 8 did not change the growth rate of Real GDP at all, so the association of black 7' with the green 7' is in doubt. The tightening of green 8 in 1986 affected M1 quickly, but the effect on M3 was slow and Real GDP growth slowed starting from 1990, a 4 year delay if we want to stretch our imagination and to attribute the tightening of green 8 as the cause of the recession marked as black 8. After the tightening of green 8, FED loosened The Federal Fund's rate around the beginning of 1989. The Federal Fund's rate bottomed out at 1992 to 1993, marked as green 8', then staged a moderate tightening starting from green 8' to 1995. This series of FED loosening and tightening created a huge up and down in M1 that peaked at blue 8'. However, those busy moves of FED were ignored by M3. When M1 was rising and falling at the beckoning of FED, M3 behaved just opposite to M1; M3 fell mightily while M1 was rising strongly, and M3 rose strongly when M1 fell significantly from 1994 to 1996. From 1996 to 1998 FED kept The Federal Fund's rate steady, and so was M1 money supply. But M3 money supply continued to rise strongly through this period. As for Real GDP, it just rose with a constant rate from 1991 to 2000, completely ignoring FED's monetary operations throughout the decade of 1990's. Some try to attribute the economic slowdown of 2000 to 2003, marked as black 9, to the tightening of green 9. But this tightening is very moderate in nature, and is unlikely to be the cause of the massive slowdown of 2000 to 2003, considering the total ignorance of Real GDP to the much larger monetary operations of FED through the decade.

It should be noted that in a gross sense Real GDP has been rising in a rather constant rate from 1955 until today. Before the onset of the globalization scheme around the early part of 1980's, FED was able to slow down that growth rate temporarily by tightening The Federal Fund's rate in order to cool down the overheating economy. However, after the set-in of the globalization scheme, FED has lost the substantial part of that power to regulate the economic expansion. The most current FED tightening has started in June of 2004 as marked by the green 10. It will be very dangerous to anticipate an eminent recession due to this batch of rising Federal Fund's rate. We must search other causes that are regulating the ebbs and flows of Real GDP growth in the era of globalization, but that discussion will be postponed to later writings.