U.S.: The Fed's Balancing Act Just Got A Lot Tougher

With inflation rising and growth slowing, rate decisions will be much riskier

Financial markets around the world have lost their footing in recent days. Stocks have plummeted from New York to Bombay since May 10, including a 5% drop in the Standard & Poor's 500-stock index. Commodity prices from industrials to precious metals have tanked. In an apparent flight to quality, U.S. Treasury securities and the dollar have both rallied. Nervous investors are left to ponder what's going on.

In a nutshell, the risk factor in global financial markets has risen considerably this year, mainly because financial pros are recognizing that the relative certainty created by a long period of easy money is coming to an end. The prospect of greater-than-expected policy tightening by the U.S. and European central banks -- or in the case of Japan, sooner-than-expected -- is creating new uncertainties in the outlook. Market players are demanding higher premiums on the money they invest for the added risk they have to take on.

Smack in the middle of this drama is the Federal Reserve. For the past two years, U.S. monetary policy has been a cakewalk for the markets. The Greenspan Fed laid out a plan to raise interest rates from levels that had become unnecessarily low, and it did just that. Now the Fed of Chairman Ben S. Bernanke has to do the hard part: decide when enough tightening is enough. The problem is, the markets are starting to get a taste of just how difficult that task is going to be.

The recent bad news on U.S. inflation means that the risks for the U.S. economy, along with the potential fallout for markets overseas, are rising. So far this year, consumer prices outside of energy and food are growing at an annual rate that is well above the 2% comfort limit of several Fed officials, including Bernanke. At the same time, the economy shows signs that it may finally be slowing down after a red-hot first quarter.

A mix of slow growth and rising inflation is one that central bankers would rather not have to face, because policy decisions become a double-edged sword: A pause in the Fed's rate hiking could allow more inflation to take hold, but continuing to lift rates to fight that possibility could cripple the economy. This is a dangerous dilemma for the Fed, and it goes a long way toward explaining why the world's financial markets are in such a stew.

INFLATION READINGS took a turn for the worse back in March, when the measures of core inflation, which excludes energy and food, unexpectedly jumped 0.3% from February. Energy and food costs matter to consumers, but the Fed looks at the core index to judge if the impact of higher energy prices is spreading to other goods and services. Then in April the core consumer price index (CPI) increased 0.3% for the second month in a row, suggesting that the March spike was not a fluke. For the past year the core rate for the CPI was up to 2.3%, and it has been edging higher since last June. Over the first four months of 2006, it was running at an annual rate of 3%, the fastest four-month clip since 1995.

Housing Costs Lift Core Inflation
That pace has been pushed up mostly by housing costs, which are rising faster only because of the way the government measures them. It uses rental rates on various properties to gauge how the monthly cost of housing is changing, and this index accounts for a huge 30% of the core CPI. But there's a quirk. When demand for homeownership was hot, rents slowed sharply, depressing this measure of housing costs. Now, with home affordability near a 13-year low, the rental market is picking up again -- and so are the housing cost readings.

The question is, how will the Fed factor this quirk into its rate decisions? Clearly, rising housing costs at a time when home prices and market conditions are softening may not reflect reality, but it can also be argued that falling rental rates during the housing boom caused the government to understate the cost of homeownership and, thus, overall inflation.

THE FED'S FAVORED MEASURE of inflation, the core price index for personal consumption expenditures (PCE), uses the same technique for estimating housing costs, but the weight is half that in the core CPI. Even so, core inflation using this gauge is also creeping up. Over the past year, through March, the rate stood at 2%. But over the first three months of 2006, the annual rate was 2.5%. Any continued tendency of this index to breach the 2% level will put pressure on the Fed to tighten policy further.

It is a pressure that, to some extent, the Fed has put on itself. Last year, when Bernanke was a Fed Governor, he described a range of 1% to 2% inflation, measured by the core PCE index, as his "comfort zone." With Bernanke now Fed Chairman, that range has seeped into the markets' thinking and into the thinking of many Fed officials. The zone is now tantamount to an unofficial inflation target.

The Fed, as a result, may have painted itself into a corner. The markets have come to expect policymakers to act to keep inflation within this range, which could make it difficult for the Fed to pause at its next policy meeting on June 28-29. The bond market, in particular, may not react kindly to the Fed suggesting a comfort zone and then allowing inflation to run above it without further action. At stake: the Fed's credibility as an inflation fighter, at least as perceived by the markets.

THE FINANCIAL MARKETS will welcome a pause in June only if the economic data imply that the economy is slowing to a pace that will allow price pressures to abate. It's far from certain just yet, but recent data suggest that conditions for a more Fed-friendly growth rate are starting to fall into place.

That's especially true for the second quarter. Housing indicators in April and May offered mixed signs, but all show slippage from last year's peaks, and high gasoline prices are eating into consumer spending and confidence. Also, several forces that created the economy's boom-like growth rate in the first quarter were temporary, including post-hurricane rebounds in several sectors and a record warm winter. Those factors sharply boosted construction activity, consumer spending, and exports, and their sudden absence in the second quarter could result in a significantly slower growth rate for overall gross domestic product.

The Downward Trend In New-Home Demand
Housing is clearly in a downtrend, although March and April gains in new home sales suggest only a gradual weakening. Regarding future activity, builders are very downbeat. The May index of builders' assessments of market conditions, compiled by the National Association of Home Builders, fell to the lowest level in 11 years.

The Fed will have to be sensitive to the speed of the housing slowdown, given its potential to harm consumer spending and the overall economy. At the same time, it must also be sensitive to financial market concerns about inflation. Unfortunately for investors, the markets will remain volatile until Fed policy finally reaches a steady state that will allow the uncertainty surrounding future Fed actions to ebb. That will happen only when the economic data indicate a more comfortable balance between economic growth and inflation.

By James C. Cooper

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