ANALYSIS: WHY FOMC WILL PROBABLY RAISE THE FED FUNDS RATE
By Steven K. Beckner
Market News International - The question for members of the Federal Open Market Committee Tuesday -- oversimplifying only a little -- is: Do we wait and hope that the economy will slow on its own with the help of firmer financial conditions, or do we act now to validate those firmer conditions and cement the slowing process?
As is so often the case when the Federal Reserve's policymaking group meets, the decision is apt to come down to a calculation of the consequences of inaction. In this case, the risk is that staying on hold would give the stock market a shot of adrenaline and depress market interest rates (already well off their highs), thereby fueling consumer demand for housing and consumer durables.
The FOMC's likely conclusion, after some agonizing, is that not taking the federal funds rate up to 5.5% from 5.25% would be just too big a risk to take, particularly when the price to pay for a little insurance is so small.
The markets, by and large, are expecting a third 25 basis point increase in the funds rate, and notwithstanding relatively quiescent inflation, such a move can be easily justified. After all, the Fed would merely be completing its disengagement from last fall's 75 basis point emergency easing which it began June 30 and continued on Aug. 24. It would be a return to approximate neutrality.
Arguably, it would be more difficult to justify not going to 5.5%. True, there have been signs of slowing, especially in home sales. True, productivity growth is up, and unit labor costs have moderated, according to the latest figures. And true, prices generally remain well-behaved.
But whether the slowing that seems to be underway is enough is doubtful. More precisely, Fed officials who have seen their forecasts of slowing repeatedly disappointed have to doubt whether the latest signs of slowing will be sustained. They have to wonder whether domestic slowing will be offset by a pickup in external demand. To the extent it merely reflects the economy's own limits, domestic slowing does not necessarily lend comfort. For the Fed to be comfortable, there has to be a reasonable prospect that slowing will ease strains on labor markets and other resources. And it has to be confident that, if the economy slows, productivity growth will not slow more.
As encouraging as productivity trends have been, can Fed officials realistically be confident productivity growth will continue to outpace gains in labor compensation? They can be hopeful, but they cannot be sure.
The Fed clearly has the leeway not to raise rates at this juncture. Although there have been some signs of wage-price pressures, the underlying rate of inflation at the retail level remains mild. Nor are there any signs of building inflationary expectations if one can judge by Treasury's inflation indexed bonds ("TIPs"). The yield on the conventional 30-year long bond has retreated from a recent peak of 6.38% to below 6.05%. The Fed has built up a tremendous reservoir of credibility against inflation, and that is reflected in wage, price and financial market behavior.
Some have surmised from official comments about low inflation and signs of slowing that the Fed is finished raising rates for the year, but that is probably a misreading. Policymakers have an interest in not sounding overly alarmed about inflation. Inflation is still relatively benign, and it would be foolish for officials to indicate otherwise.
But it would also be imprudent to send a signal of complacency. "Benign" though it may be for the present, inflation is not invisible. Although producer prices for finished goods fell 0.1% last month, they were up 0.3% excluding food and energy, and core intermediate prices rose 0.4%. Core crude prices were up 2.4%. In September, core consumer prices were up 0.3%. The "beige book" survey prepared for this FOMC meeting found that "prices remain stable" but detected "some notable exceptions" -- "increases in prices were noted for some manufacturing inputs, health care, memory chips and construction materials."
On the wage front, the third quarter Employment Cost Index looked reassuring, rising just 0.8% (3.1% compared to a year earlier). And the third quarter productivity report showed unit labor costs rising just 0.6%, thanks to a 4.2% rise in productivity. Average hourly earnings were up a mere 0.1% in October, following September's 0.5% rise. However, labor compensation was up 4.8% in the third quarter, according to the same productivity report, and the beige book found wages accelerating in five districts going into the fourth quarter.
The near-term consequences of staying at 5.25% would not be great. Inflation is not about to accelerate markedly next week or next month or next quarter. But the longer term consequences could be substantial. The Fed's hope is for a soft landing, but inaction could lessen the chances of that happening.
Although some Fed watchers foresee the funds rate going to 6% or more next year, most Fed policymakers seem to think the Fed is close to where it needs to be at this time -- close, but not necessarily there. As St. Louis Fed President William Poole told Market News International recently, the Fed has "about the right stance," but "that's not the same as saying we're exactly where we're going to stay. ... I don't think we're very far off." Another, far less hawkish policymaker indicated he had no strong feelings against a 25 basis point move, telling Market News International, "The world won't come to an end if we go to 5 1/2."
The implication is that a modest further upward adjustment is all that is needed for the time being. The danger. of which policymakers are acutely aware, is that, if that adjustment is not made now, more dramatic rate adjustments may be required later.
So FOMC members have to ask themselves: Why push our luck?
The other thing arguing for modest action now is that this will be the Fed's best window of opportunity for awhile. It is unlikely the Fed would want to raise rates because of year-end liquidity concerns amplified by Y2K. The Fed is poised to pump in extra liquidity and that would be a bad time to be trying to snug money market conditions to edge up the funds rate. Nor is it apt to want to raise rates between the December 21 and February 1-2 meetings. So if it does not raise rates now, the next opportunity would be February -- a good ways down the economic pike. |
