The Federal Reserve's policy meeting on Jan. 30-31 was more notable for marking the Fed's first anniversary under Chairman Ben S. Bernanke than for the widely expected decision to keep the target interest rate at 5.25%. After Bernanke's shaky start in the big oval table's hot seat, questions about his resolve in fighting inflation, communication with the markets, and his discretion about policy comments around reporters have become moot. Bernanke has won the respect of both Wall Street and Washington, and Fed policy has received high marks from both camps, especially on the timing of the decision to stop raising rates back in August.
Now comes Chapter Two. The early pages look boring, but hang on. With the economy apparently emerging from its slowdown and inflation edging lower, Fed policy will very likely remain unchanged for at least the next several months. The calm should allow policymakers to concentrate on their discussions of how best to communicate their policy ideas to the markets, with a special focus on setting a numerical target for inflation.
Deeper into 2007, though, Fed policy could turn into a real page-turner. In 2006 the Fed attempted to find a level for interest rates that would be high enough to keep inflation under control yet avoid an outright collapse in housing that could send the economy spiraling into a recession. Mission accomplished: From all recent signs, home demand is now firming. Sales of new homes in December increased for the fourth time in the past five months, and the stock of unsold homes is shrinking.
This means, by the middle of the year, housing may not need any more special consideration from the Fed. If the rest of the economy continues to be as strong as it is now, the absence of the drag from housing could cause growth to heat up several degrees too high for the Fed's comfort. That would put the possibility of rate hikes back on the table, a prospect Wall Street is clearly not prepared for and one that would bring the Fed considerable political scrutiny from the new Democratic Congress.
THE LABOR MARKETS are fast becoming the Fed's central focus, and they are at the heart of both the economic and the political stories. Last year the Fed forecasted the economy would slow enough to allow inflation to ebb. It got that part right. Indeed, the Fed delivered a much more upbeat appraisal of both economic growth and inflation in its statement following the Jan. 31 rate decision. However, last year the policymakers also expected slower growth to unwind some of the tightness in the labor markets and foster confidence that rising labor costs would not reignite inflation. That part, they missed.
Last July the Fed projected the unemployment rate, which began the year at 4.7%, would end the year in the 4.75% to 5% range. However, the rate fell further, hitting 4.5% in December, a sign that job markets were getting tighter not looser. That's why the Fed's Jan. 31 statement highlighted "the high level of resource utilization" as a potential threat to future inflation. It's also why the policymakers continue to lean toward the need to raise rates, not lower them.
SURPRISINGLY STRONG economic growth in the fourth quarter means the economy has picked up to a pace that, if sustained, will push the jobless rate even lower. The Bureau of Economic Analysis reported on Jan. 31 that real gross domestic product increased at an annualized rate of 3.5% during the fourth quarter, and the breakdown of the report suggests continued strength. Led by a solid 4.4% advance in consumer spending, demand in all sectors increased at a healthy 4.2% rate, despite the biggest quarterly decline in outlays for new housing since the 1990-91 recession. Housing will almost certainly be a drag on growth in the first quarter as well, but not nearly as large as in the fourth quarter.
The other big minus last quarter came from inventories, but that is set to turn around, too. Inventory growth slowed sharply, subtracting 0.7 percentage points from real GDP, but the slowdown means businesses have taken a big step toward reducing their bloated stockpiles, especially unsold autos. The reduction will help clear the way for a reacceleration in production in coming months, a speedup that has already been seen in the faster pace of December manufacturing output.
Consumers are leading the growth pickup, because they are feeding off the strength in the labor markets. That was clear from the Conference Board's January index of consumer confidence, which rose to the highest level in nearly five years. Fewer households characterized jobs as "hard to get," while the proportion saying jobs were "plentiful" was the largest since 2001. Those jobs are generating big gains in incomes.
The Fed's potential problem in 2007 lies on the flip side of strong labor income: higher labor costs for businesses. The Fed's concern is that the economy will be strong enough to allow companies to pass their rising costs on to consumers in the form of higher prices. The minutes from the Fed's Dec. 12 meeting made a special note of rising labor costs as an inflation risk.
The Labor Dept.'s fourth-quarter employment cost index, an accounting of hourly wages and benefits, shows the upward drift. The ECI for private-sector workers, which economists believe is the most accurate gauge of hourly pay and benefits, rose 3.1% from a year ago, and the pace edged up though the year. Benefits slowed, but wage growth picked up notably, a result of tighter job markets that may only get tighter.
THE FED WILL come under greater political scrutiny in Bernanke's second year, especially if the policymakers feel compelled to lift interest rates due to tight labor markets. Bernanke is sure to face questions on this subject when he makes the Fed's semi-annual report on monetary policy to Congress on Feb. 14 and 15, speaking before the Senate Banking and House Financial Services Committees. The new chairman of Financial Services, Representative Barney Frank (D-Mass.), has been outspoken recently about the Fed's commitment to jobs and wages, and he opposes Bernanke's long-held desire to establish a numerical target for inflation.
The February testimony may give Bernanke his first opportunity to defend his inflation-targeting ideas. The Fed continues to discuss the strategy in the context of how to communicate its policy more openly, but progress has been slow. Frank is against the plan out of fear that setting a target for inflation alone would dilute the central bank's congressionally mandated responsibility "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." Bernanke will have his hands full trying to explain to Frank and others why focusing only on inflation does not demote the importance of employment within the Fed's multipronged mandate.
One thing is certain: If the Fed has to lift rates later this year, it will raise the ire of both Washington and Wall Street, except that the markets won't voice their displeasure in words. Their anger will be felt in lower prices for stocks and bonds.
By James C. Cooper