Although the economy has slowed and downside risks have risen, those clamoring for an easing of monetary policy may still have to wait. In fact, there is no guarantee the Federal Reserve’s next move won’t be to raise interest rates.
The direction of rates depends, of course, on how the output and inflation data evolve. Right now, the outlook is uncertain, as Fed Chairman Ben Bernanke has said.
Uncertainty does not lend itself to snap policy judgments. Nor is there any compelling reason to shift policy in either direction. So the best bet is that the Fed’s rate-setting Federal Open Market Committee (FOMC) will keep the federal funds rate at 5.25%, for the indefinite future.
Part of the Fed’s policy stance is what it says about policy going forward, and it’s also unlikely there will be much change there. For the foreseeable future, the FOMC will keep some form of a tightening bias.
At its March 21 meeting, a wording change in the FOMC’s rate announcement sent a wave of excitement through Wall Street in the mistaken belief that the Committee had “dropped the bias” and “gone neutral” in preparation for rate cuts before long.
In fact, the FOMC modified, but did not drop, its tightening bias. True, by deleting “the extent and timing of any additional firming that may be needed” it removed the presumption that the next move would be a rate hike. But it continued to lean in that direction by saying its “predominant policy concern remains the risk that inflation will fail to moderate as expected” — after calling core inflation elevated and warning that “the high level of resource utilization has the potential to sustain those (inflation) pressures.”
The FOMC was not necessarily saying it would have to raise rates at some point. What it was signaling was that it will not ease just because the economy is softening so long as inflation remains unacceptably high.
Testifying before Congress a week later, Bernanke said he wanted to emphasize that we have not shifted away from an inflation bias.
Soft economic data kept alive hopes for easing. According to the Commerce Department’s advance estimate, real gross domestic product (GDP) grew 1.3% in the first quarter. But this was primarily due to continuing housing sector weakness, which the Fed expects to ebb as the year wears on. Consumer spending has remained robust.
The bigger Fed concern has been disappointingly slow business fixed investment, but there have been tentative signs of improvement, and the fundamentals for capital spending are strong.
Although officials have been citing increased downside risks and uncertainties, they expect GDP growth back near 3% later this year. Some early second quarter data look promising.
Barring some shock that disrupts financial markets and derails the expansion, and the Fed does not see the subprime mess as such a shock, the real policy issue is the still worrisome inflation outlook. The Fed has been forecasting moderating inflation for quite a while, yet core inflation has stubbornly been stuck above the top end of its implicit 1% to 2% target range for the last three years.
Favorable March readings were welcomed at the Fed. The price index for personal consumption expenditures excluding food and energy (core PCE) was flat and up just 2.1% year-over-year, after rising 0.3% and 2.4% in February. The core producer price index was likewise unchanged, and the core consumer price index rose just 0.1% (2.5% year-over-year).
But it will take more than a month or two of such data and/or evidence that GDP is not bouncing back as expected to convince the Fed that lower rates are needed.
The Fed is counting on contained inflation expectations to help bring actual inflation down to around 2%, but would like some help from increased slack in resource use. That’s another quandary. Slack is hard to measure, but with unemployment at 4.5% and labor costs accelerating, the Fed doesn’t see much slack left.
How much slack might open up depends on how fast the economy grows relative to its non-inflationary growth potential. Because of slower productivity growth and reduced labor force participation, the Fed has lowered its estimate of potential growth to no more than 3%. If the Fed’s forecast proves correct, not much slack will be created and, hence, not much inflation relief, especially because slow productivity growth threatens to drive up unit labor costs.
While policymakers do not expect rapid progress, they hope to get gradual moderation of inflation and sustained modest expansion, the proverbial soft landing. And they see their current policy stance as consistent with achieving that goal. They see financial conditions generally, particularly in wake of record-setting stock market gains, as supportive of growth. So there is little inclination to move rates up or down.
Steve Beckner is senior correspondent for Market News International, which sponsors his Web site “The Beckner Report.” He is regularly heard on National Public Radio and is the author of Back from the Brink: The Greenspan Years (Wiley).
