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Why the Fed Is Ready to Cut Again

By Rick MacDonald The Federal Reserve's mission has changed much since 1913, when Congress created the central bank. The act passed by lawmakers back then states that the Federal Open Market Committee (FOMC), the Fed's policy-setting arm, should seek "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." Historically, the Fed has seen an inherent trade-off between growth and inflation, although it has often struggled to express such a complex, dynamic notion in a concise statement for the markets and the public.

So, consider the May 6 FOMC post-meeting statement, which raises the possibility of deflation (see BW Online, 05/06/03, "The Fed Identifies a New Peril"). Given that the FOMC doesn't make changes lightly, this new risk assessment may mark something of a historical twist for the central bank: The Fed could be signaling the possibility of easier monetary policy based on fears of an "unwelcome substantial fall in inflation" -- even if the outlook for growth supports keeping rates steady.

Since the Fed shifted to the new way of assessing economic risk in 2000, every press release up until the last two have included the following boiler-plate: "Against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks are..." Depending on its outlook at the time, the Fed would then insert one of the following:

"...weighted mainly toward conditions that may generate economic weakness,"

"...balanced with respect to the prospects for both goals for the foreseeable future," or

"...weighted mainly toward conditions that may generate heightened inflation pressures for the foreseeable future."

NEW WORD ORDER. The Fed's parsed statement sought to make clear the perceived policy trade-off regarding maximizing growth and guarding against inflation.

Something significant occurred in the last two post-meeting announcements: The Fed has changed the wording of the risk statement. On Mar. 18, the FOMC took a pass on characterizing the balance of risks, saying the "unusually large uncertainties clouding the geopolitical situation in the short run and their apparent effects on economic decision-making" made assignment of reasonable risks impossible.

And despite the U.S. military victory in Iraq -- which should have lifted the geopolitical clouds to a significant degree -- the FOMC did not revert to its previous method of assessing risk at the May 6 meeting.

SEPARATE ASSESSMENT. Instead, the Fed made a concerted effort to separate the risk assessments for economic growth and inflation. The press release indicated that "Although the timing and extent of that improvement remain uncertain, the Committee perceives that over the next few quarters the upside and downside risks to the attainment of sustainable growth are roughly equal" for the overall economy (see BW Online, 5/9/03, "What Postwar Pickup?").

The inflation picture merited its own assessment: "In contrast, over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level." The upshot: "Taken together, the balance of risks to achieving its goals is weighted toward weakness over the foreseeable future."

Thus, the Fed has effectively indicated it has a bias to ease again -- and not because of its outlook for growth, which has historically been the justification -- but because of its concern over inflation, or lack thereof. In a sense, if the risk of rising prices is small, which the Fed apparently believes, then it has no reason not to try to speed-up growth.

GROWTH INSURANCE. The signal from Greenspan & Co. seems to be that another easing is in the offing. But the Fed also appears to be making a clear distinction that such a move wouldn't be because of the "double-dip" fears that are embedded in the forecasts of most Fed watchers who are calling for another cut.

Instead, it's almost like the Fed is seeking the spoils of higher growth after declaring victory over inflation. And with deflation concerns lingering, apparently at least some members of the Fed see no reason not to take out more insurance. The only question may be whether it will be the tried-and-true route of rate cuts or some more unconventional approach. MacDonald is a senior economist for MMS International

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