One of these days, the Federal Reserve is going to raise interest rates, but don’t hold your breath.
Notwithstanding surprisingly strong second quarter gross domestic product growth, the Fed still has grave doubts about the economic outlook given continued housing and financial market fragility. And, if the Fed believes its own forecast, inflation should moderate with the help of lower oil prices, a stronger dollar and increased slack in resource utilization.
While some Federal Reserve Bank presidents are eager to start tightening monetary policy, and while all Fed officials recognize the eventual need to normalize rates to contain inflation, there was no sign as this was written of a critical mass for early rate hikes.
After stepping into a slight tightening bias on June 25, the Federal Open Market Committee (FOMC) tiptoed back to a symmetrical stance at the Aug. 5 meeting. “Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee,” the Fed noted in keeping the federal funds rate at 2%.
By contrast, the prior statement had said, “Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased.”
The FOMC thus signaled it was in no rush to shift policy. As the FOMC observed, “labor markets have softened further and financial markets remain under considerable stress. Tight credit conditions, the ongoing housing contraction, and elevated energy prices are likely to weigh on economic growth.”FOMC minutes revealed divisions, but also clearly showed a consensus to approach policy firming cautiously.
Though only Dallas Fed President Richard Fisher voted to raise rates, the minutes say “a number of participants worried about the possibility that core inflation might fail to moderate next year unless the stance of monetary policy was tightened sooner than currently anticipated by financial markets.” Presumably, Philadelphia Fed President Charles Plosser was one, having dissented previously and having said the Fed needs to reverse the 325 basis points of easing from September 2007 to April 2008 “sooner rather than later.” But the majority was content to wait: “most members did not see the current stance of policy as particularly accommodative.”
Chicago Fed President Charles Evans, a mainstream thinker who will be an FOMC voter in 2009, said 2% is “not especially stimulative...the financial market turmoil has meant that our funds rate reductions have led to less credit expansion to households and businesses than typically would be the case.”There was no sense from the minutes that rate cuts were near.
“Although members generally anticipated that the next policy move would likely be a tightening, the timing and extent of any change in policy stance would depend on evolving economic and financial developments and the implications for the outlook for economic growth and inflation.”
At the Kansas City Federal Reserve Bank’s annual Jackson Hole symposium, Chairman Ben Bernanke reinforced this stand pat message in a speech mostly devoted to “Reducing Systemic Risk.”
“The financial storm ... has not yet subsided, and its effects on the broader economy are becoming apparent in the form of softening economic activity and rising unemployment,” he said, explaining that the FOMC had retained a “relatively low” funds rate “in view of the weakening outlook and the downside risks to growth.”
Bernanke said the Fed’s strategy “has been conditioned on our expectation that the prices of oil and other commodities would ultimately stabilize, in part as the result of slowing global growth, and that this outcome, together with well-anchored inflation expectations and increased slack in resource utilization, would foster a return to price stability in the medium run.”
Most importantly, he suggested the Fed’s approach was being validated: “..(T)he recent decline in commodity prices, as well as the increased stability of the dollar, has been encouraging. If not reversed, these developments, together with a pace of growth that is likely to fall short of potential for a time, should lead inflation to moderate later this year and next year.”
Obviously the FOMC won’t keep the funds rate at 2% indefinitely, but unlike the European Central Bank, whose narrow focus on inflation has led it to raise rates, the Fed is also commanded to maximize growth and jobs, which necessitates financial stability.
Atlanta Fed chief Dennis Lockhart, another 2009 voter, put it succinctly, “I doubt...many people would be happy with attempts to solve the problem of high oil prices through policies that would deliberately reduce the real incomes of American consumers and wage-earners.”
The Fed has a difficult balance to strike. If financial and other strains cool growth and dampen inflation, the Fed could stay on hold a good while longer. If, on the other hand, markets stabilize and the economy rebounds, we could see a fairly swift tightening.
Steve Beckner is a senior correspondent for Market News International. He is the author of “Back From the Brink: The Greenspan Years” (Wiley).