The Wall Street Journal

June 17, 2008 

 

The Federal Reserve is almost certain to leave interest rates unchanged when it meets next week, and it currently doesn’t appear to see a compelling case for raising rates before the fall, unless the inflation outlook deteriorates considerably.
Futures markets are betting that the central bank is likely to raise its interest-rate target from its current 2% in August, because of mounting inflation worries. But that may be an overly aggressive wager.
An August rate hike can’t be ruled out. Between now and then, a raft of economic data, including two employment reports and several gauges of inflation, will be released. If the overall economy and the financial system show signs of rapid improvement or the inflation news worsens significantly, the Fed may decide to start reversing some of the rate cuts that began last September.
But for now, Fed officials want to both demonstrate their vigilance against inflation risks, particularly from soaring energy prices and the weak dollar, while also giving the economy time to recover from the trouble in the housing, labor and financial markets.
As a result, the Fed’s policy statement following its meeting next Tuesday and Wednesday is likely to use stronger language about the risks from inflation than in May, but is unlikely to go so far as to ratify market expectations of a rate hike as soon as August.

If the Fed were to hold off raising rates, it would have a broad impact on American households and businesses, by keeping pressure off the interest rates paid on home mortgages and corporate borrowing. Lower borrowing costs are a key to spurring an economic recovery after months of sluggish growth.

An important factor is complicating the economic outlook: Energy prices have surged in recent weeks, which threatens to weaken growth further while pushing the overall pace of inflation higher.

In recent days, markets have seized on comments made last week by Fed Chairman Ben Bernanke that suggested a greater focus on inflation concerns, and particularly on the public’s expectations of a rise in inflation. “The latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations,” he said in a speech on June 9. He said that the Fed “will strongly resist” allowing inflation expectations to get out of hand. When people believe prices are bound to rise, workers tend to seek wage increases and businesses to mark up their prices, boosting inflation.

The speech fueled expectations that rate hikes would occur sooner than markets previously anticipated. On Monday, futures markets put the likelihood of a quarter-point rate increase at the Fed’s August meeting at 90%. Futures markets also indicate that investors expect Fed rate hikes at meetings later this year, which would bring the target for the Fed’s benchmark federal-funds rate — at which banks lend each other funds overnight — to at least 2.5%. Last month, traders didn’t expect any rate hikes until the end of the year.

But Mr. Bernanke also said in his speech that the housing contraction and energy-price surges “suggest that growth risks remain to the downside,” even though the risk that the economy “has entered a substantial downturn” had fallen.

There is so far little evidence that either underlying inflation or the public’s long-term inflation expectations have reached a danger point. Mr. Bernanke and most other officials believe inflation expectations remain under control. The pace of inflation, excluding volatile energy and food prices, has remained near the top of the Fed’s preferred range of 1.5% to 2%, based on its preferred price index. And with the economy weak, workers are unable to win wage gains in a way that would send inflation spiraling higher. The latest data show wage gains actually slowing — the opposite of what has occurred in Europe, where rising wages are triggering tough anti-inflation rhetoric from the European Central Bank.

What’s more, Mr. Bernanke and other Fed officials believe financial markets remain especially fragile. Raising rates soon could worsen those troubles, hitting the mortgage sector and lengthening the housing downturn.

“The outlook for the financial crisis would worsen,” said Tom Gallagher, an analyst at brokerage ISI Group. The Fed usually doesn’t stop easing rates until the unemployment rate peaks, Mr. Gallagher notes, and a peak in jobless figures hasn’t necessarily happened yet. If rate hikes were to start soon, “the Fed would be tightening well in advance of the traditional indicators.”

Some recent economic data, particularly retail sales, have demonstrated that consumers remain resilient. But some of that strength is likely coming from the rebate checks the government has sent out in its $152 billion economic stimulus program.

Several presidents of regional Fed banks have expressed strong concerns in recent months about the inflation outlook. That could lead to more dissent at the upcoming meeting, continuing a string of minority opposition since last fall.

Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, said in a speech Monday that the Fed should be prepared to raise rates as the risks of weaker growth diminish. But Mr. Lacker, who is generally hawkish on inflation, also suggested a willingness to hold rates steady for now, by noting that inflation expectations haven’t gone “adrift.”

“We seem to have dodged this risk so far,” Mr. Lacker said. “Inflation expectations are higher than I would like, but are relatively stable.”