Some are convinced the Federal Reserve is finished cutting interest rates and that its next move will be to raise them, but there is little certainty about either the timing or direction of monetary policy.
The Fed’s rate-setting Federal Open Market Committee (FOMC) culminated 325 basis points of easing at its April 30 meeting. And that’s not all. It has launched three new emergency credit facilities to provide liquidity to what Dallas Federal Reserve Bank President Richard Fisher called the “clogged pipes” of the financial system.
On March 16, a “day which will live in infamy” for Fed critics, the Fed not only financed JPMorgan Chase’s takeover of Bear Stearns, it also began lending to other major investment banks for the first time since the Great Depression. It’s up to historians to judge whether the Fed’s nonstop and ongoing struggle to contain the subprime mortgage crisis will prove to be its “finest hour.”
Certainly, the Fed will have learned some lessons about the consequences of leaving rates too low for too long in the 2001 to 2004 period and about the need for better financial supervision.
San Francisco Fed President Janet Yellen admits that, in the run-up to the subprime mortgage crisis the Fed and its fellow regulators were behind the curve. “We missed some of the risky developments that were unfolding,” she says. But what’s next for monetary policy? That will depend on how economic and financial conditions evolve. The nub of the debate is this: rising energy and food prices have been pushing up headline inflation.
Inflation expectations have deteriorated. But at the same time, high energy costs, along with continued financial strain and the housing correction, are keeping the economy weak. These crosscurrents raise questions about whether the Fed should forego further rate cuts and look toward raising rates soon to curb inflation, or whether it should focus on dealing with lingering economic weakness and financial stress on the assumption that slow growth will curb inflation.
Fed signals have been mixed. The FOMC dropped its explicit easing bias from its April 30 rate announcement, but minutes of the meeting show “most members thought that the risks to economic growth were still skewed to the downside.” And indeed the FOMC lowered its growth forecast for 2008. It also revised its inflation forecast up “moderately,” but while it predicted inflation “will moderate” over the next two years, it projected unemployment will remain fairly high through 2010.
Many Fed watchers seized instead on the minutes’ revelation that members noted that it was not appropriate to ease policy in the near term in response to evidence of a slowing or contracting economy unless economic developments “indicated a significant weakening of the economic outlook.”
A couple of officials have publicly echoed that sentiment in addition to the two Fed presidents who opposed the last rate cut. But several members does not equal a majority.
On numerous occasions since the April 30 FOMC meeting, Chairman Ben Bernanke has had an opportunity to signal that the Fed is finished easing, but has not done so. Twice in May Bernanke said financial markets have shown “some improvement” but are “still far from normal.” He embellished on that in a June 3 speech, but still gave no clear indication what the Fed might do next. He said the United States is experiencing upward pressure on inflation, but also said economic growth faces “significant headwinds” as consumers and firms deal with falling house prices, a softer job market, tighter credit and high fuel costs.
Influential Vice Chairman Don Kohn said the FOMC would keep a close eye on inflation, but added they need to assess whether the economy is likely to be on track for sustained economic expansion in light of the current softness. It’s Kohn’s judgment that “monetary policy appears to be appropriately calibrated for now.” But he cautioned, “a large measure of uncertainty surrounds that judgment.”
The picture that has emerged is of a divided and unsure Fed that has lapsed into a watchful waiting mode — a time for letting monetary and liquidity measures work and hoping for the best. It’s hardly in some sort of comfort zone. It remains on alert. As the FOMC said, it “will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.”
It’s a bit premature to presume that the Fed is finished easing and that the next rate move is higher. Given the continued downside risks and uncertainties about which even more hawkish FOMC members continue to talk, I think we could be in for another “considerable period” of low rates.
Steve Beckner is a senior correspondent for Market News International. He is the author of Back From the Brink: The Greenspan Years (Wiley).