There's still no end in sight for the ultra-easy monetary policy. The economy is recovering, but at a subpar pace, with continued high rates of unemployment and no increase in inflation. The Federal Reserve’s favorite core price index for personal consumption expenditures (PCE) has slowed from 1.5% to 1.2% since January.
The wave of risk aversion from Europe has increased uncertainty, reducing support for raising interest rates in the near future.
True, the Fed has been honing its reserve draining tools -- making ready reverse repurchase agreements and term deposits for eventual use. But the rate-setting Federal Open Market Committee (FOMC) is sincere in saying it expects the near zero Fed Funds rate to stay “exceptionally low...for an extended period.”
The tightening process will only begin when the FOMC alters that policy guidance, causing markets to push up rates. Only then will the Fed begin draining reserves. Next will come official rate hikes and asset sales later still. The Fed is not going to surprise the market. So far, it has not tried to prepare the market.
Kansas City Fed President Thomas Hoenig has dissented at every FOMC meeting against making a tacit zero rate pledge, warning it is creating financial imbalances. And he has said the Fed needs to move the funds rate up to 1% soon. But his has been a lone voice. Fellow voter St. Louis Fed President James Bullard has advocated early asset sales to shrink the balance sheet, but said in late May the Fed is “really nowhere near a tightening” of policy.
Chairman Ben Bernanke has often said weak job markets and tight bank lending are headwinds impeding robust recovery. He has supplemented the Fed’s easy official credit stance by leaning on banks to ease their credit flows. He says removing the dramatic monetary stimulus of the past few years is a “medium-term” proposition.
Incoming Fed Vice Chairman Janet Yellen is expected to support keeping policy loose indefinitely because of the large output gap Ñ the difference between actual and potential GDP. She’ll likely get support from other Obama appointees to the Board of Governors. Governor Daniel Tarullo, soon to be one of four appointees, has suggested the European crisis may continue for an extended period.
“Coming as it does on the heels of the financial crisis that began in 2007, and with economic recovery here in the United States proceeding at only a modest pace, the European sovereign debt problems are a potentially serious setback,” he told Congress.
Similarly, New York Fed President and FOMC Vice Chairman William Dudley says “the recovery is not likely to be as robust as we would like” for several reasons: continued “deleveraging” by households, “significant stress” in the banking system curbing lending, and the “temporary” nature of some recovery forces.
“Coupled with the benign outlook for inflation, these headwinds to growth and employment explain why the Federal Reserve [is] keeping short-term interest rates unusually low,” Dudley adds.
Most of the tough policy decisions will come next year. But among the four Fed presidents who will join Dudley as FOMC voters, the only clear vote for tightening is Philadelphia Fed President Charles Plosser.
And even he’s not automatic. The European crisis “raises some clouds on the horizon that we have to be cautious about,” he says.
Other incoming voters sound even less hawkish. “I still see [that] we can maintain the balance sheet for an extended period and with uncertainty in financial markets I wouldn’t be surprised if that was extended a bit more,” says Chicago Fed President Charles Evans.
Minneapolis Fed President Narayana Kocherlakota says the FOMC will raise the funds rates when it is “appropriate,” whether that means “three weeks, three months or three years.” He added that the FOMC is concerned with unemployment and that there seems to be little threat of inflation.
Dallas Fed President Richard Fisher says they are not close to tightening and the “extended period” language is contingent on “low rates of resource utilization, subdued inflation trends and stable inflation expectations.”
The FOMC’s latest quarterly, three-year forecasts relative to its “longer run” projections are instructive. As of late April, governors and presidents projected the unemployment rate will end this year between 9.1% and 9.5%, before falling to between 8.1% and 8.5% next year, and to 6.6% to 7.5% in 2012. The “longer run” unemployment projection is 5.0% to 5.3%.
That longer run unemployment forecast amounts to a Fed assumption about the non-accelerating inflation rate of unemployment (NAIRU). While the FOMC has nudged NAIRU up a bit, it remains quite low. The lower it is, the more room the Fed has to delay tightening.
Some think NAIRU has risen as much as two percentage points due to the financial crisis, but the majority believes NAIRU has risen just slightly, if at all, and that the Fed should wait until unemployment falls to between 7% and 8% before tightening.
Meanwhile, FOMC members project longer run PCE inflation of 1.7% to 2.0%. Not until 2012 do they expect actual inflation to reach the upper end of that range. Expect no change in policy until a majority of FOMC members believe GDP, employment and inflation are going to rise faster.
Steve Beckner is senior correspondent for Market News International. He is regularly heard on National Public Radio and is the author of “Back From The Brink: The Greenspan Years” (Wiley).