WSJ.com: Real Time Economics
Economic insight and analysis from The Wall Street Journal.
Fed Should Seek to Manage Risks on the Way Up, Too
FedThe Federal Reserve seems in recent months to have taken a risk-management approach to fighting economic weakness, cutting rates sharply to avoid a worst-case scenario of what officials have referred to as a possibly "severe" downturn.
They should take the same approach to raising rates now that those risks have receded and the sooner the better — at least when it comes to articulating that strategy.
In a January speech, Fed governor Frederic Mishkin laid out the risk-management strategy on rate cuts this way: "By cutting interest rates to offset the negative effects of financial turmoil on aggregate economic activity, monetary policy can reduce the likelihood that a financial disruption might set off an adverse feedback loop," he said.
The Fed lowered the target fed funds rate at which banks lend money to each other by 3.25 percentage points between September and April to 2%. In a nine-day stretch alone in January, the Fed cut the funds rate by 1.25 percentage points. It sliced it another 0.75 percentage point in March and again raised the issue of risk management in the minutes of that meeting.
"Some participants expressed concern that falling house prices and stresses in financial markets could lead to a more severe and protracted downturn in activity than currently anticipated," the minutes stated. "All in all, members judged that a 75-basis-point easing of policy at this meeting was appropriate to address the combination of risks of slowing economic growth, inflationary pressures, and financial market disruptions," according to those March meeting minutes.
Yet economic risks have receded, Fed Chairman Ben Bernanke signaled Monday. "Although activity during the current quarter is likely to be weak, the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so," he said.
A retail sales report for May, released Thursday, further reduced those risks, with sales up 1% signaling a solid rise in second-quarter consumer spending of around 2% or 2.5%. That, in turn, should boost overall economic growth from last quarter's 0.9% pace. Still, the outlook for 2008 as a whole hasn't changed all that much, since faster growth early in the year probably means somewhat slower growth in the second half, especially with energy and food prices up sharply.
Still, "if you're working on a risk-management basis and you've been guarding against the worst, if you've decided that's much less likely and you're looking at unpleasant inflation numbers, the conclusion is you're going to raise rates," said Nigel Gault, chief U.S. economist at Global Insight.
"If you're at this [fed funds] rate because of the baseline forecast then you shouldn't be close to the trigger point" for higher rates, said Brian Sack, a former Fed economist now with Macroeconomic Advisers. But, "if you thought there were downside risks to the baseline forecast and those have diminished," then some quick reversal may be in order.
There's one problem, Sack said: "We're left not really knowing how much of [the easing cycle] was perceived as risk management and how much was the baseline forecast."
At stake is whether the Fed starts raising rates next year, as former Fed governor Lyle Gramley expects, or in August or September, as Wall Street increasingly seems to think. "At some point,[(rate hikes are] a logical course of action, [but] we're not there yet," Gramley said.
On the other hand, J.P. Morgan Thursday moved forward its forecast of a Fed rate hike to September, explaining that "downside tail risks" to growth and financial stability "were a central motivation behind the Fed's decision to ease aggressively," and now those risks are "moderating."
Barry Bosworth, an economist at the Brookings Institution, argues the 2.25 percentage points in rate cuts since January — almost all of which occurred over a two-month period — were largely based on risk management, not the baseline forecast. After all, "forecasts [from] a year ago are basically what we got," he said, referring to very slow growth, but probably not a recession.
Even if only half the 2008 cuts were risk-management related, that's more than a full percentage point up for grabs.
Bosworth expects the Fed to raise rates by one-quarter point at its August meeting, which would set the stage for a half-point hike later in the year.
That, in turn, could reduce pressure on energy prices, Bosworth said, which need to "break downward soon."
Stressing the risk-management aspect to both cuts and hikes would get the Fed around another potential dilemma, raising rates while the jobless rate increases.
But if the Fed's going to make that case, it needs to do it soon. "If you thought there was never that much going on but there was this big shock that raised temporarily the threat of a big collapse and they responded to that…if that's the case you have to take [the rate cuts] back quickly," Bosworth said. –Brian Blackstone
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Economists React: Concerns About Inflation Expectations
Economists and others weigh in on the 0.6% jump in consumer prices.
# Not surprisingly, the major driver of the sharp jump in the headline was a 5.7% spike in gasoline prices. Also, utility rates jumped 2.3%. Looking ahead, it appears that gasoline will show an even sharper advance in June ? somewhere in the neighborhood of +9% based on current quotes. So, headline CPI is likely to post an even sharper rise in June than the 0.6% posted in May? We continue to believe that core inflation [which excludes food and energy] will hold reasonably steady over the balance of 2008 and may even tick down a bit. This reflects an expectation of continued significant deceleration in the [Owner's Equivalent Rent] (which accounts for a little more than 30% of the core!) and residential rent categories as vacant properties are transitioned to the rental market. This anticipated deceleration in the key shelter category of the CPI (which accounts for about 40% of the core) should help to offset any spillover effects tied to higher food and energy prices. –David Greenlaw, Morgan Stanley
# The primary question left outstanding, is when will those headline increases begin to visibly show up in the core. Right now, what has mitigated a much sharper rise in core prices, which by the way at 2.3% on an annualized basis is well above the implied target range at the Fed, is the muted rise in the housing component over the past few months. Moreover, firms that have had to adjust to a decelerating economy have only partially passed through the tough rise in headline costs to the consumer. It is our assessment that over the remainder of the year that firms will reach a breaking point with respect to the amount of pain that can be absorbed vis-à-vis already razor thin profit margins and begin to pass along those costs. –Joseph Brusuelas, Merk Investments
# I doubt that the headlines covering these data in tomorrow's local newspaper will convince the general public that they should be marking down their inflation expectations. This is a key point that will take some getting used to, so I will restate it. When inflation expectations are "well-anchored" (that is, the public trusts the Fed), it is the Fed's opinion on the inflation outlook that matters. When inflation expectations start to drift, then the Fed's outlook is relevant, but it is actually the public's view on the future course of prices that is paramount. Even if the Fed thinks inflation will be fine, if the public is ratcheting up their expectations, legitimately or not, the Fed has no choice but to respond. Right now, we are in the verbal jawboning phase of that process, and if that doesn't work, then the Fed will have to hike rates whether they want to or not. –Stephen Stanley, RBS Greenwich Capital
# The main takeaway from this report is the troublingly high level of headline inflation. While normally the Fed could take comfort that anemic growth and increasing slack in the labor market would draw inflation lower in the months ahead, with headline inflation at 4.2% they will likely remain concerned about a destabilization in inflation expectations. –Zavh Pandl, Lehman Brothers
# The trends in the CPI data will no doubt make for some interesting discussion within the [Fed]. No matter how much faith one is willing to put in core inflation, and we put next to none, inflation expectations are more influenced by total inflation, at least those expectations formed on Main Street as opposed to Wall Street. But, for those worried about a return of 1970s style inflation, one huge difference between now and then is the fact that workers have considerably less bargaining power today than was the case during the 1970s. Thus, even if workers come to expect persistently higher inflation, they have less power to bargain for higher wages, meaning the type of wage-price spiral seen during the 1970s — and accommodated by the Fed — is unlikely today. So, given their concern over the downside risks to economic growth and the health of the U.S. banking system, elevated readings on headline inflation will continue to elicit tough talk from the FOMC, but we see little chance of them acting, in the form of Fed funds rate hikes, for the remainder of 2009. –Richard F. Moody, Mission Residential
Compiled by Phil Izzo |
