The Federal Reserve took a leap of faith at its latest policy meeting -- faith in its economic forecast, that is -- and both the stock and bond markets leaped with it. The statement following the central bank's June 29 hike in its target rate, to 5.25%, for the first time suggested the Fed believes demand is slowing in a way that will eventually take pressure off inflation. Such a scenario would suggest, in turn, one more rate hike at most, and the Fed would finally be out of Wall Street's hair. The markets zoomed on that prospect, but now comes the big question: Does the Fed have it right?
Maybe, but don't bet the ranch just yet. Growth in the second quarter is clearly cooling down from the first quarter's red-hot pace, which the government has now revised up, for the second time, to a sizzling 5.6% annual rate. Consumers and housing are leading the second-quarter slowdown. Most housing indicators are running below their first-quarter levels, and consumer spending after adjusting for inflation barely rose in both April and May.
Those two sectors will continue to strain under the weight of higher interest rates and gasoline prices in the second half, but the depth and breadth of any slowdown in the broader economy isn't clear. Economic reports at the end of the quarter, especially those from the labor markets, look a little firmer than earlier ones. Plus, indicators of overall financial conditions, from the credit markets to bank lending to international finance, still look supportive of demand.
With the likelihood of a lasting cooldown still not certain, the policymakers have put themselves in a tricky situation with the markets. That's because the trend in inflation tends to lag behind that of economic growth. For instance, inflation outside of energy is picking up now in large part because of past strength in overall demand and easy monetary policy. So if the economy is indeed slowing, it will take a while longer for inflation to ease.
THE KEY ISSUE AT STAKE resulting from this lag is how the markets view the Fed's credibility as an inflation fighter. By backing away from the need to raise rates while inflation readings remain elevated, the Fed could be seen as being dovish on inflation. This perception could breed expectations of higher inflation, which would begin to reinforce the recent uptick in the price indexes. Indeed, bond-market measures of expected inflation rose a bit after the Fed's statement.
The most interesting feature of the June 29 hike was the striking contrast between the hawkish comments of various Fed officials prior to the meeting and the decided lack of such hawkishness in the official statement. Its wording suggests that the Fed would like to pause, perhaps for fear of overtightening policy and hurting the economy. So the Fed's earlier strong anti-inflation rhetoric, coming as it did in the face of ugly-looking April and May price indexes, appears to have been less of a signal of future policy and more reflective of efforts to assure the markets of a commitment to fighting inflation.
Against this backdrop, July 19 should be a very interesting day. That's when Fed Chairman Ben S. Bernanke treks up Capitol Hill to deliver the Fed's semiannual Monetary Policy Report to the Senate Banking Committee. The chairman will also lay out the Fed's forecast for growth and inflation. If the June 29 statement is any guide, the Fed's projections are not apt to deviate much from its February outlook, which showed growth slowing from 2006 to 2007 by just enough to allow inflation to edge lower next year.
A new round of Bernanke's Fedspeak is reason enough to expect a volatile day in the markets. But this time the June report on the consumer price index comes out the same day as his testimony. That's a potentially explosive mix, especially if the inflation data look bad.
BERNANKE COULD END UP in the position of defending the Fed's sanguine forecast in the face of contrary inflation reports that argue for more rate hikes. A senator might logically ask: "Well, Mr. Chairman, if you expect growth to moderate and inflation to ease, why even consider another rate hike?" Despite the recent downbeat price indexes, inflation hardly looks out of control. The Fed's preferred measure of core inflation, which excludes energy and food, rose a moderate 0.2% from April. The 12-month rate has fluctuated in the narrow band of 1% to 2.5% for the past decade. As of May, the 12-month rate is 2.1%. So far this year, the comparable five-month annual rate is 2.6%.
Wall Street sees this dilemma as one in which the Fed must prove its credentials as an inflation fighter by taking action with interest rates, not with words. While it's absurd to question the Fed's inflation-fighting resolve, it's not out of line to question its forecast, especially at a time when policy based on those projections could lead to a mistake that could cost the economy dearly later on.
The Fed's June 29 statement left plenty of wiggle room for policymakers to react to future data on the economy. But if the central bankers' forecast is on the mark, the upcoming numbers on economic growth will be much more important than the readings on inflation. Since a slower economy is the sine qua non for slower inflation, signs that growth is moderating will be crucial to giving the Fed the credibility it needs to stop lifting rates.
THE PROBLEM IS, THE BIGGER RISK right now is that the data will not cooperate. Despite the economy's slowing in the second quarter, it remains uncertain that a cooler pace will prevail in the second half. Fewer jobless claims in June and a report of strong June job growth by ADP Employer Services suggest robust labor markets. June car sales edged up a bit from May, and Detroit is readying a new round of generous sales incentives.
Perhaps the most important reason to question whether the economy will gear down enough to send the Fed to the sidelines is that financial conditions, while less liberal than a year ago, remain far from restrictive. That's true both in the U.S. and globally. Central bank policy rates, adjusted for inflation, in the euro zone are well below those in the U.S., and they are negative in Japan.
For U.S. households, mortgage rates have moved up by more than a percentage point over the past year, to 6.9% for a 30-year fixed mortgage, but that's hardly painful for most borrowers. And while stock prices have been volatile this year, the broad Wilshire 5000 stock index, a good proxy for the stock portion of household net worth, is still about 8% ahead of a year ago and more than 15% ahead of two years ago.
For corporations, the credit markets remain receptive to borrowers, and surveys show banks also remain eager to lend. Finally, the dollar is still 17% below where it was in early 2002, and foreigners remain willing to use their stronger currencies to finance dollar-based investments.
With inflation ticking up, look for Fed officials to continue to speak forcefully and carry a big stick. And as long as the policymakers' forecast for slower growth remains unproven, the stock and bond markets will be vulnerable to a sharp reversal from their June 29 rallies.
By James C. Cooper