The Wall Street Journal

16 April  2010

High Unemployment, Slow Inflation Shape Policy, but Some Officials Worry About Preserving Flexibility to Shift Gears

Federal Reserve officials are likely to end their policy meeting later this month by reiterating that they expect to keep interest rates low for “an extended period”—despite uneasiness among some policy makers that the words limit the Fed’s flexibility as the economy improves.

It is expected that central-bank officials will use speeches and interviews to emphasize that their commitment to hold rates near zero depends largely on how the economy behaves.

More-robust consumer spending has made policy makers more confident that a sustainable recovery has taken hold. With unemployment still high, inflation slowing and stable expectations for future inflation, top officials now see little urgent need to start signaling they are near raising rates. But if the outlook shifts, they say their stance will move.

Private economists surveyed by The Wall Street Journal have pushed back their expectations for the moment that the Fed might start raising rates. On average, 56 analysts who responded to survey questions in early April said they didn’t expect the Fed to move until November; two months ago the economists were predicting September. On average, they believe the federal-funds rate, an overnight bank-lending rate that the Fed is now holding at about 0.20%, will rise to 0.75% by December, a bit more than futures markets anticipate.

For the Fed, managing expectations is a delicate task, influenced greatly by the words it chooses. Since March 2009, the Fed has said in each post-meeting statement that it expected the economy’s performance to justify keeping short-term rates near zero for “an extended period.” The phrase was chosen to encourage investors to buy long-term bonds, which would keep long-term interest rates low, by signaling the Fed wouldn’t move for a long time.

Officials now want to make sure the phrase doesn’t handcuff them. Some policy makers have become frustrated that the statement is sometimes interpreted as an ironclad commitment to keep rates low for at least an additional six months. But dropping the closely watched words is unappealing, because it could be misinterpreted as a signal that a rate increase is imminent. So officials are looking for ways to underscore that their plans are conditional.

“Everything depends on how the economy performs,” James Bullard, president of the Federal Reserve Bank of St. Louis, said in New York on Thursday. Speaking more broadly last week about how the Fed’s exit from easy money policies will unfold, Fed governor Daniel Tarullo said, “it seems to me neither necessary nor advisable to decide upon a single game plan that will be announced in advance and rigidly implemented after a decision is made to raise rates.”

Charles Evans, president of the Federal Reserve Bank of Chicago, who has equated the “extended period” phrase to about six months, sought to emphasize the flexibility in an interview Thursday. ” ‘Extended period,’ it is a guideline. It is not an ironclad agreement,” he said, adding, “it will be quite some time before we need to make an adjustment” to policy.

Mr. Evans and several other officials have been struck by how much inflation has slowed in recent months. The last consumer-price index showed that prices outside the volatile food and energy sectors contracted at a 0.2% annual rate in the first quarter, though commodity-price pressures have held up broader measures of inflation.

The 56 economists surveyed by The Wall Street Journal, not all of whom answer every question, were split over near-term inflation risks: 23 economists said accelerating inflation was a bigger risk in the next year and 23 said slowing inflation was the bigger risk. Over the next five years, though, 45 among 52 said the risks of accelerating inflation outweigh the risks of slowing inflation.

“The Fed dropped the funds rate to near zero due to a fast and sharp decline in economy. Having avoided a 1930s-type scenario, is a 0% policy rate still justified?” said Joseph Carson of AllianceBernstein. “We criticize banks for offering teaser rates to buy homes, but the Fed is offering a teaser rate for the entire economy.”

On average, the economists expect the U.S. unemployment rate, currently at 9.7%, to fall only slightly, to 9.3% by December, another reason for the Fed to stand pat. “The Fed doesn’t want to start raising rates when you haven’t got really solid employment momentum,” said economist Kurt Karl of Swiss Re. The forecasts anticipate the U.S. will add around 1.9 million jobs over the next 12 months, a small fraction of the more than eight million jobs lost during the recession.