–Barclays Maki: Is the New Natural Unemployment Rate at 7%?
–MS Greenlaw: Cant Say Fed Won’t Hike Until Jobless Rate Below 9%
–BA/ML’s Levy: Fed Should Be Proactive In Removing Accommodation
–Market News International Hosts Panel of Fedwatchers

By Sheila Mullan

NEW YORK (MNI) – David Greenlaw, Morgan Stanley chief U.S.
economist, Wednesday night said that his firm feels the Fed will
tighten rates in September and he projects a 3.2% GDP in 2010 and 2.5%
in 2011, in large part contingent on higher rates in the second
half of next year.

“Core inflation would bottom over the next few months, move back up
toward 1% at the end of 2010, and 2% by 2011,” Greenlaw said. He spoke
as part of a New York panel of economists assembled by Market News
International and moderated by MNI Fed reporter Steve Beckner.

Another panel participant, Barclay’s Dean Maki, suggested a key Fed
assumption, that the natural rate of unemployment is still 5.5%, is
wrong, and it is actually now appreciably higher.

But on the fiscal policy side, the Fed will be fighting such
battles as the U.S. budget deficit and, Greenlaw said, “that triggers in
our view some meaningful movement in the 10-year U.S. Treasury yield,
which is at 3.75% now, and will be at 5.5% by the year-end.” He added,
“The Fed will also raise the fed funds rate to 1.5% by the end of this
year.”

“We are a little bit uncertain about our Fed call,” he went on.
“Our expectation has always been that the market will be pushing the
Fed.”

The Fed will be watching such things as inflation expectations from
a survey basis and also from a market basis, he said. “In particular, I
would suggest focusing on the 5-year/5-year forwards, which remains
relatively benign at this point due to economic travails created by the
Greek economic woes and the “benign” core U.S. CPI, he added.

But he also said that “the Fed is exiting an extraordinary
expansion of accommodation. I don’t think we can say that the Fed will
not tighten until unemployment is below 9%.”

He noted that the exit from the Fed’s accommodative policy will be
a two-stage process and cited Fed Chairman Ben Bernanke’s statement in
recent months that such exits may be a simultaneous process and that the
Fed can reduce its balance sheet at the same time as it is tightening.

Greenlaw added that “if the interest on excess reserves does not
work, the Fed has to do a massive drain operation.” He added that,
“We’ve got a big budget deficit. It is not going away any time soon.”

Dean Maki, Barclays Capital chief economist, noted that, “We
believe that business has simply overreacted and cut back too much on
business spending.”

He added that “business sentiment is turning much more
expansionary” and added. “We think the concern on consumer spending and
deleveraging is overdone. Consumer and business spending is readily
driving our growth.”

Maki noted that, “We are looking for a 9% unemployment rate by the
end of this year, with risks to the downside.” The U.S. population is
“simply quite a lot older” thus less employment is needed to stabilize
the employment situation, he added.

He said that “our own view is that the natural rate of
unemployment is 7%” but the “Fed tells us 5.5%” is the natural rate. He
cautioned, “As the unemployment rate keeps falling you run a very
different problem”q of inflationary pressure … . It’s a very risky
strategy if the natural unemployment rate has risen more than we think
it has,” he added.

“In the 1970s, the natural rate was thought to be around 4%,” Maki
said. “Now, we look back and see it was something around 7%. Now we look
back and say this was something that led to inflation.”

“We think the Fed will start edging rates up later this year,” the
Barclays economist said. He noted that since the FOMC started using the
“extended period” language, the “Fed has changed the meaning of extended
period, without changing the language itself,” making its meaning more
flexible and economic situation dependent, than a strict time period, he
added.

“In my mind, that language does not mean very much,” said Maki.
“Our view is that Fed would like to change the extended period language
in advance but it may not necessarily be able to” if economic conditions
force its hand

“We expect the Fed to drain reserves first” in its quantitative
easing exit, he added, then doing moves on interest on excess reserves
and then potentially doing simultaneous tightening in the key fed funds
rate.

Mickey Levy, chief economist at Bank of America, suggested that the
Fed needed to be proactive about its exit from accommodative policy. He
added that the Fed’s policies are “inconsistent with the Fed’s long run
objectives” as a “a negative Fed funds rate is an absolute
disequilibrium.”

He added that “the timing of the Fed moves depends on the Fed’s
objectives” but also warned that the threats from a Congress that seeks
to lessen the power and independence of the Fed, so to speak, “are
real.”

“Monetary stimulus works with a long and variable lags,” he added.
“But once it gains traction, it can be very powerful. I concur that the
economy is going to outperform. The core members of the Fed rely
aggressively on a GDP model,” he continued. “The GDP gap model has been
notoriously unreliable, he said, and cited the 1970s GDP and inflation
situation wherein accelerating inflation was missed until too late.

“I see in the last two quarters that nominal GDP is accelerating,”
said Levy. “I am not saying that inflation is coming back right now.
But Dave made the point that the market is going to lead the Fed not
just because the Fed does not want to surprise the market but the Fed
also has to deal with Congress.”

He asked, rhetorically, “How long can the Fed keep the real fed
funds rate negative, as the economy is accelerating and gaining
traction? Once the money multipliers stabilize, the Fed to be very
careful. The reverse repos are only temporarydraining operations.

“The market is going to lead the Fed,” he added. “And after a
couple more months of strong employment numbers, the Fed is going to
change the language.”

— By Sheila Mullan, New York, 212-669-6432 smullan@marketnews.com

** Market News International New York Newsroom: 202-371-2121 **

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