Save and target of the Fed

Publié le par Jean-Pierre Chevallier

M2-M1 continuous to increase at 8.64% (year-on-year) from September 10 to 17, which means that Americans increase their saving by decreasing their consumption.
Graph 1:

As demand drops, supply adapts: the real GDP growth slows down logically.
Americans increase their saving because they estimate that their situation will be degraded because of the maintenance of the Fed target is at too high levels.
Indeed, too high rates increase the cost of the loans, therefore of all the projects of investment, which causes a deceleration of the economic activity.
Graph 2:

The Fed has just lowered its basic rate on September 18, but it is too late.
The deceleration of the growth is already important: the growth of this third quarter is as well as possible 1.7% year-on-year, i.e. 0.3% compared to the second quarter (in annualized rate).
Graph 2 is carried out on this assumption, but the growth can be even weaker and even negative.
The increase in M2-M1 from May 2005 to June 2006 corresponds to the increase in the rates of the Fed which reached its top at 5.25% on June 29, 2006, which means that Americans well understood that the raising of this rate was going to slow down the activity: they increased their saving, which slows down the demand, therefore the real GDP growth.
The real GDP growth started to lower 6 months after the raising of the Fed target above its level of neutrality at 4.25%.
Indeed, the Fed increased its basic rate at 4.5% on January 31, 2006 and the real GDP growth which was at 3.2% in the second quarter 2006 fell to 2.4% in the third quarter.
Since this date, the real GDP growth is lower than its optimal potential at 3.5% because the Fed maintains its rates too high.
The decisions of the Fed act on the real economy with a 6 months deadline for… more than 50 years! see my previous papers on the free money supply.
To make set out again the growth, the Fed should have lowered its rate at 4.25% what corresponds to its neutrality.
As the members of the FOMC did not make this decision, a negative growth is extremely probable for this fourth quarter 2007.
However, as the American economy is very strong, the growth can set out again very quickly, and stronger than to be envisaged.
The neutrality of the rate of the Fed can be a little higher than 4.25% because American economy is very strong and very healthy.

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