U.S.: The Fed: Another Failure To Communicate?

It must convince the markets that higher rates can still accommodate growth

It's becoming increasingly evident that some of the economy's surprising third-quarter strength is spilling over into the fourth quarter. Consumers are heading into the holiday buying season with plenty of cash, growing wealth, and hints of renewed confidence in the job markets. Business confidence in the future is also on the rise, judging by the surge in third-quarter profits, the sudden need to replenish depleted inventories, and the September jump in new orders for capital equipment. It's the most positive mix of growth forces that the economy has enjoyed in more than three years.

But while the improving outlook is brightening moods from the family room to the boardroom, it may soon cause some problems for policymakers at the Federal Reserve. Amid surprisingly strong economic growth, the Fed now faces a delicate task: shifting its policy message.

Any actual hike in interest rates is not likely until well into 2004. But at some point, perhaps sooner that it had anticipated, the Fed will have to start preparing the markets for an eventual tightening of policy after already having told them in August and September that "policy accommodation can be maintained for a considerable period." The markets interpret this as the Fed's intention to keep rates down. Any backtracking on that risks roiling the markets and cheapening the Fed's credibility.

THAT'S WHY ALL EYES were on the Fed's statement following its Oct. 28 policy meeting. As expected, the policymakers left the overnight federal funds rate steady at 1%, but Fed watchers were more concerned with whether or not policymakers might try to back away from their previous sanguine views on the outlook. With only one slight alteration, however, its accompanying statement was a carbon copy of the one in September.

Compared with its September missive, the Fed noted the nascent improvement in the labor markets, but its assessments of the risks in the outlook regarding both growth and inflation remained the same. On growth, it reiterated that the risks were evenly balanced between the expansion being too strong and too weak. As for inflation, the Fed repeated that the risk of its being too low was greater than that associated with its being too high.

Most important, and of greatest interest to the markets, the Fed reasserted its belief that interest rates could stay at levels that were accommodative to growth for a considerable period. Both the stock and bond markets rallied strongly after those words. But given the economy's new momentum, policymakers may soon have to start sending a much less market-friendly message.

Fed Policy Is Highly Stimulative
Preempting deflation and jump-starting lackluster demand have been the main focus of policy. But that was back when the Fed was forecasting growth from late 2002 to late 2003 of only 2.5% to 2.75%, a pace that implied growth in the second half of only about 3%. Second-half growth will far outstrip that forecast, and the economy seems set to power into 2004.

The Fed noted in July in its twice-yearly Monetary Policy Report to Congress that given strong productivity and the existing slack in the use of labor and other resources, "demand could grow at a solid pace for some time before generating upward pressure on inflation." But whatever cushion the Fed had expected to have against the need to lift interest rates is now sure to get used up faster than the Fed had anticipated.

WHAT FED WATCHERS WANT TO KNOW IS: Will the economy's strength force the Fed to renege on its promise to keep policy accommodative for a long time? The Fed has already raised hackles in the bond market once this year over an alleged miscommunication about what policymakers might or might not do to address the threat of deflation.

The potential problem brewing is that bond players think the word "accommodative" means a 1% federal funds rate. But at least two Federal Reserve district bank presidents have already suggested that "accommodation" does not necessarily mean that the federal funds rate cannot rise above 1% (chart).

These officials point out that the funds rate is already far below the level that in the past has been associated with a neutral Fed policy, that is, one that neither accommodates nor restricts economic growth. They note that there is considerable room for the funds rate to rise, while still maintaining an accommodative policy.

Indeed, the real federal funds rate, which is the market rate minus inflation, is one indicator of the currently extreme degree of policy accommodation. It has been running between zero and -1% during the past year, far below its long-run average of about 2.5%, which is considered to be an approximation of the rate consistent with a neutral policy. With inflation about stable, that means the funds rate can rise a couple of percentage points, even while keeping policy accommodative.

ALMOST EVERY ECONOMIC REPORT in recent weeks suggests that the economy is gathering steam faster than almost anyone had expected. In September, combined sales of new and existing homes hit another record. Plus, consumer confidence rose in October, according to the Conference Board. Confidence is a good ways from regaining its recession losses, but households think both current and future conditions improved last month, and fewer described jobs as "hard to get."

Perhaps the most important sign that strong demand is finally starting to absorb excess production capacity comes from the long-depressed manufacturing sector, which is now showing new signs of life. September orders taken by makers of durable goods rose 0.8%, and their growth over the past four months has been the strongest in three years. The same is true for the pace of shipments going out the door, and factory capacity utilization, while still low, has begun to increase.

One reason: Demand is shrinking factory inventories to unsustainably low levels, and that will spur more orders, boost output, and lift hiring. The September ratio of durable-goods inventories to sales fell to a record low.

A Key Sign of Rising Business Confidence
Moreover, businesses are ramping up their outlays for new equipment at an increasingly rapid rate (chart). September orders for capital goods, excluding aircraft, jumped 3.9% from August. From the year before, new bookings are up a hefty 13.5%, a yearly growth rate not seen since the late-1990s boom in capital spending. Orders for computers and electronic products are up 18.4% from the previous year, a yearly pace that surpasses growth rates seen in the late 1990s.

The most interesting aspect of the Fed's status quo policy statement on Oct. 28 was that, even in the face of mounting evidence that the economy is outperforming policymakers' expectations, the Fed made no move to back away from its stated intention toward future policy accommodation. That may only intensify any jolt to the markets, especially in the bond market, when the Fed begins to change its tune. Given the economy's new vigor, that day might well come sooner than the markets now expect.

By James C. Cooper & Kathleen Madigan

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