re: FOMC meeting
ANALYSIS: FOMC APT TO STAY ON HOLD, BIASED TOWARD TIGHTENING
11:47 EDT 06/26 --But FOMC Doesn't Face Easy Choice; Can't Rule Out Rate Hike as 'Insurance' Against Possible Future Inflation
By Steven K. Beckner
Market News International - Although the pendulum of market sentiment has swung heavily in favor of an expectation that the Federal Reserve will leave interest rates unchanged following two days of meetings Tuesday and Wednesday, Fed policymakers will not face an easy choice.
As most of the economic indicators turned soft in recent weeks, it became conventional wisdom that the Fed's policysetting Federal Open Market Committee would remain on hold at its mid-year meetings. Not that "conventional wisdom" is to be demeaned or disregarded. The Fed pays a great deal of attention to the consensus of market opinion, not just because it regards market sentiment as a worthwhile indicator in itself but because, ordinarily, the Fed does not wish to surprise the market.
Could the June 27-28 FOMC meeting be one of those occasions when the Fed decides the markets need to be surprised? The odds do not favor it (otherwise, it wouldn't be a surprise), given the amount of tightening already performed and the complexion of the recent economic numbers. But a rate hike remains possible.
Although some Fed watchers say the Fed has done enough tightening and that its next move is likely to be a rate cut, there is little of such thinking among Fed officials, at least among those now voting on the FOMC. On the contrary, there is a strong suspicion that they have "more work to do." Of how much more they are unsure.
In their heart of hearts, some policymakers believe the right thing to do would be to approve another modest, "insurance" rate hike now, rather than wait until the Aug. 22 FOMC meeting. There are apt to be those who will broach the case for taking the federal funds rate up another 25 basis point notch to 6.75% without delay.
But as best one can judge, there is insufficient support for further rate action this week. And it would appear that not even the most hawkish policymakers think the case for further action now is compelling enough to go to the mat and dissent against standing pat. Their druthers seem likely to give way to their sense of what is prudent and realistic at this juncture.
Nevertheless, there is a case to be made, and it will be.
To begin with, if the FOMC passes up this chance to raise rates, the next regularly scheduled opportunity before the November election would be the Oct. 3 meeting. Beyond that comes the Nov. 15 post-election meeting.
The Fed has always publicly disavowed letting the election cycle divert the course of monetary policy. If push comes to shove, i.e. if the data warrant, the Fed will change rates in the run-up to an election. But the Fed would prefer not to move any closer to the election than it can help. That predilection puts a premium on squeezing whatever further pre-election tightening the Fed deems to be needed into the July and August meetings.
If recent signs of a slowdown are sustained, there is no problem. The Fed can bask in the satisfaction that its 175 basis points of tightening through mid-May did the job, with help from higher fuel prices acting like a tax hike on Americans' disposable incomes.
However, officials are not confident the May data constitute a real, sustainable or sufficient slowdown. The nine-year expansion has gone through temporary lulls before, and in any case, the slowdown comes from a very rapid pace -- well above even the Fed's upwardly revised notions of the economy's non-inflationary growth potential. Moreover, the cooling of domestic demand, to the extent it is real, coincides with a somewhat offsetting pickup of demand from abroad.
Policymakers find even less believable the May employment report's suggestion that, suddenly and inexplicably, American workers stopped demanding bigger wage gains to catch up with productivity improvements and to keep up with faster consumer price inflation. Whatever their motivations, participants in the workforce find themselves in a position to demand higher wages, salaries and benefits, and until the last employment report, all indications were that they were doing just that. It strains the Fed's credulity to imagine that such behavior simply ceased last month.
Another worry for the Fed is that overall financial conditions remain relatively accommodative, despite its six rate hikes. Rates on mortgages and corporate bonds are well off their highs. Bank credit is still growing rapidly. Money growth remains above target, with M3 expanding at an 8.6% rate, reflecting in good part the funding of commercial and industrial loans. And the stock market remains its seemingly irrepressible self.
The Fed doesn't want to implode the financial markets, but it questions whether financial conditions are responding to its rate hikes sufficiently to get the job of trimming the economy's sails done.
Of course, as the economy slows and demand for credit diminishes, one would expect market rates to come down, and the Fed hopes this is what is happening. But the risk, of which officials are very conscious, is that softer-looking economic numbers un-firm financial conditions and restimulate the economy.
On the second day of FOMC meetings this week, the committee is most likely to conclude that, at the very least, recent data have created enough uncertainty about the outlook to justify a pause in the credit-tightening process to allow past rate hikes to work. It is just possible, perhaps probable, that last year's undoing of 1998's 75-basis-point easing, plus this year's additional 100 basis points of actual tightening are starting to bite and will bite further in months to come.
Therefore, the FOMC is apt to decide to reassess economic and financial conditions in August and, in the meantime, stay tilted toward tightening.
The less likely scenario is that the FOMC yields to the siren song of the hawks, which hypothetically goes something like this: "Look, although the economy may have slowed, we can't count on the slowdown lasting. Besides, it's still growing at an unsustainably rapid pace at a time when foreign demand is picking up. Labor markets are still tight as a drum, and labor cost increases are in danger of accelerating. And unless we encourage a further firming of financial conditions we run the real risk of accommodating higher labor, oil and other costs and setting the stage for an inflation break-out. Let's face it, we all know that rates have to go higher -- probably another 50 basis points, at least -- and if we don't move now, we could find ourselves having to do more than we'd like to do before the election. So if the risks are weighted toward higher inflation, why wait?"
Aside from its rate-setting function, this particular FOMC meeting has traditionally been the occasion for formulating the "central tendency" economic forecasts and money growth targets for the mid-year Humphrey-Hawkins Report. The Humphrey-Hawkins Act has expired, but all indications are that the Fed will continue its past pattern. There is no incentive to break the mold at this point. |
