From the October 01, 2006 issue of Futures Magazine • Subscribe!

Fed at a crossroads

It’s not getting any easier for Federal Reserve Chairman Ben Bernanke and his Fed colleagues to make monetary policy. There are tough choices ahead.

Some might differ and maintain that having suspended interest rate hikes on Aug. 8, the Federal Open Market Committee (FOMC) can now just stay on hold until an opportune time presents itself to cut rates. But it’s not that simple.

It was not an easy or automatic decision to leave the federal funds rate at 5.25%, as Richmond Fed President Jeffrey Lacker’s dissent attests. Inflation was running well above the Fed’s “comfort zone,” and while there were indications the economy was slowing, it was not certain how deep or sustainable the slowing would be.

And while the indicators have tended to bolster Fed hopes that moderating expansion and other factors will reduce wage-price pressures, there are still a lot of uncertainties about the outlook. It is not a foregone conclusion that the Fed is finished raising rates or that its next move will be to ease credit.

The FOMC has left itself ample room to resume raising the funds rate. True, its August rate announcement said “inflation pressures seem likely to moderate through time, reflecting contained inflation expectations and the cumulative effects of monetary policy actions and other factors restraining aggregate demand.” But it went on to say, “Nonetheless, the Committee judges that some inflation risks remain…. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”

Despite the careful, balanced language, many concluded the FOMC had relaxed its concern about inflation. Odds of further tightening in the futures markets plummeted.

But officials have sought to disabuse such speculation, stressing the FOMC is keeping its options open. As well they might. For while there have been signs of economic softness, particularly in housing, the case has not been proven that the economy is headed for recession or even for growth so subpar as to significantly reduce resource utilization.

What’s more, even with July’s more modest 0.2% rise, the core consumer price index was up 2.7% compared to a year ago. Inflation expectations, by some measures, have risen. Manufacturers have reported increases in prices received and in prices paid. So it’s premature to declare victory over inflation, and officials know it.

Atlanta Fed President Jack Guynn said on Aug. 22, “Over the medium term inflation should begin to move back down,” and therefore, “policy seems to be properly calibrated.”

But Guynn, an FOMC voter, hastened to add that his view about monetary policy would change if inflation fails to recede. In that event the FOMC “would need to rethink.” Guynn is not known for emotional outbursts, but when a reporter suggested the FOMC increased its tolerance of core inflation above the 1% to 2% range, he exclaimed, “Absolutely not!” He said that would be an absolutely wrong reading of the FOMC statement.

He also disputed claims that the Fed’s next rate move would be lower, saying those making such predictions are “trying to think too far ahead.” Policy could go in either direction.

Chicago Fed President Michael Moskow was even more emphatic: “My assessment is that the risk of inflation remaining too high is greater than the risk of growth being too low. Thus some additional firming of policy may yet be necessary to bring inflation back into the comfort zone within a reasonable period of time.”

Before the FOMC largely removed the policy accommodation put in place during 2001 through 2003, there was substantial unanimity on what the Fed needed to do, although a few Fed watchers prematurely urged a pause.

Since Bernanke succeeded Alan Greenspan in February, the judgment calls have gotten trickier and the market consensus has dissipated. There have been wild swings in market sentiment about policy as the tone of the data and official comments have varied. The latest swing has been toward expecting the Fed to stay at 5.25%, if not lower.

What the Fed actually ends up doing will depend on the economic and inflation picture. Observers’ rate expectations tend to reflect their own economic forecasts. Not being a forecaster, this columnist can’t predict where the funds rate will be at year’s end or by mid 2007.

But it can’t be denied the U.S. economy has shown incredible resilience

in the face of energy price spikes and other shocks in recent years. And it can be confidently stated the Fed won’t take chances with inflation. So don’t bet against another “insurance” rate hike or two.

Steve Beckner is senior correspondent for Market News International, which sponsors his Web site HYPERLINK "http://www.becknerreport.com/blog/" The Beckner Report. He is regularly heard on National Public Radio and is the author of Back From the Brink: The Greenspan Years (Wiley).

About the Author
Steven K. Beckner

Steve Beckner is senior correspondent for Market News International. He is heard regularly on National Public Radio and is the author of "Back From The Brink: The Greenspan Years" (Wiley).

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