The Fed: What the Pros Are Saying
The Federal Reserve finds itself at a critical juncture as Ben Bernanke & Co. approach the June 24-25 Federal Open Market Committee meeting. Despite 300 basis points in rate cuts since last August, the U.S. economy continues to show signs of weakness, and financial markets are still skittish in the wake of the subprime-fueled credit crisis. But policymakers are growing increasingly wary of the threat posed by rising food and energy prices, How will the Fed handle the various challenges at the June meeting? BusinessWeek and S&P MarketScope staff compiled the thoughts of leading Wall Street economists and strategists:
Marc Chandler, Brown Brothers Harriman
What the Fed says will likely be more important than what it does. The statement following the meeting is likely to be about five paragraphs in length and echo some of the recent comments from Fed Chairman Bernanke and other senior Fed officials.
The first paragraph will simply be a summary of the decision to keep rates steady at 2.0%. The second paragraph is the Fed's assessment of the economy. This will likely be similar to the April statement when the Fed said, "…economic activity remains weak." However, given the upward revisions to back-month retail sales data and the fact that, contrary to some surveys, American households appear to be spending a greater part of the tax rebates, the FOMC may tone down a bit its assessment that household spending has been subdued. Following Bernanke's recent comments, the Fed may acknowledge that the risk of a significant contraction of the U.S. economy appears to have eased in recent weeks.
In the third paragraph, the Fed provides its assessment of inflation. Here the wording is likely to stiffen a bit to reflect that commodity prices have continued to rise and that inflation expectations appear to be creeping higher. The FOMC will likely signal not just that it will "continue to monitor inflation developments carefully," as it said in March and April, but will likely indicate that it is on heightened alert or something in that vein.
The fourth paragraph is the Fed risk assessment. It will likely indicate that the ongoing liquidity provisions and past rate cuts can be expected to mitigate the systemic risks to the financial system and the significant downside risks to the real economy. The last sentence of the paragraph will probably be the typically boilerplate promise to do whatever is needed to promote sustainable growth and price stability.
The fifth and last paragraph includes the details of the voting. In April, both FOMC members [Richard W.] Fisher and [Charles I.] Plosser opposed the rate cut, preferring no change in rates. They both dissented at the March meeting, too. A dissent in the face of leaving rates on hold would be a more hawkish development as it would suggest that they wanted to hike rates now.
Jan Hatzius, Goldman Sachs (GS)
Given the current economic data, the federal funds rate is well below the levels implied by standard monetary policy rules. This type of reasoning has led some commentators to argue that while aggressive monetary easing may have been an appropriate response to the "tail risk" of a deep recession in March and April, rates now need to rise because this risk has not materialized. We disagree with this view.
First, monetary policy isn't as easy as it looks as money market spreads are wide, financial conditions excluding the direct effect of short-term interest rates are tighter than last summer, and credit availability has deteriorated sharply. Second, our own outlook for growth and inflation implies that a 2% funds rate will look quite appropriate by 2009, not just from a risk management perspective but also in terms of the central case.
Third, even though Fed officials seem to have a more upbeat view of the economy than we do, history shows that a rising unemployment rate is a strong impediment to rate hikes even if the funds rate is below its "equilibrium" level. A substantial increase in long-term inflation expectations could change our view because it entails a risk that Fed officials might squander the hard-won credibility gains of the [Paul] Volcker and [Alan] Greenspan years. So far, however, the evidence for such an increase is very limited.
All this suggests that the FOMC will make only small changes to its policy statement at the June 24-25 meeting.
Gabriel Stein, Lombard Street Research
More Fed spokesmen are joining Bernanke in warning of higher interest rates. [James] Bullard, the president of the St. Louis Fed, notes that the Fed must act later in the year to curb inflationary expectations or face a loss of credibility; Fisher of the Dallas Fed says that the upcoming moves to raise interest rates must be deliberate and part of a gradual process. It is indeed beginning to look as if the Fed really will raise interest rates, most likely in August or September, October probably being too near the elections.
However, it is difficult to avoid getting the impression that the Fed has reversed President Theodore Roosevelt's dictum and is speaking loudly while carrying a twig. Not because the U.S. could not do with higher interest rates. In fact, if anything, the surge of hawkish statements are a powerful admission that the Fed's near-panic slashing of interest rates since last September was a mistake. Arguably, it helped the financial system by enabling banks to strengthen their balance sheets, but the injections of liquidity are likely to have been more important, as witness the fact that they (so far) have done the job in the euro zone. But, by comprehensively trashing the dollar, the rapid interest rate cuts also stimulated U.S. inflation.
Steven Wieting, Citigroup (C)
Eight of 10 postwar U.S. recessions have been associated with spiking consumer prices and subsequent disinflation. We have long suspected demand-destroying summer 2008 inflation rates near 5% on surging energy costs, which are globally determined.
Difficult financial conditions and slowing nominal wages suggest demand deterioration and eventual pushback on prices and profit margins. Cost pressures are rising, but sales at higher prices are far from certain.
Aside from cyclical effects, the U.S. has experienced a whiff of stagflation as the broad consumer price index has risen at a 3.6% pace in the past four years, while real gross domestic product grew 2.1%. Oil price gains have proven surprisingly persistent to both monetary policymakers and financial markets, driving that result. There is no monetary solution to product shortages such as oil. Policymakers have rightly warned that steps may be needed to resist pass-through effects if aggregate demand imbalances persist, but only if they persist.
Yet even food and energy demand is eroding at the margin.
Fed tightening is not imminent. But don't be surprised if tightening follows a growth-favorable oil price drop.
David Wyss, Standard & Poor's
Data continue to suggest no Federal Reserve action at [the June 24-25] Open Market Committee meeting. We do not expect any change until the second quarter of next year.
The primary worry at the Federal Reserve is now inflation. Oil prices keep hitting new highs. However, the core producer price index (excluding food and fuel) rose a relatively tame 0.2% in May, the same as the core CPI reading, to give the Fed more reason to stay neutral.
On June 3, Fed Chairman Bernanke said that the Fed is concerned about the rise in some longer-term indicators of inflation expectations. Fed funds futures indicate expectations that the Fed will raise rates 50 basis points by November, to 2.5%. Although it depends on the data, we expect the Fed to remain on hold until mid-2009.
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