Bernanke and the Fed Won't Raise Rates Any Time Soon
The second half of 2008 is shaping up to be a crucial period for the economy and the Federal Reserve. After a resilient first half, growth appears to be slipping again owing to continued weakness in housing, tighter credit conditions, high energy prices, and sagging labor markets. The Fed already has cut its target interest rate to a level that, by historical standards, should be extremely stimulative. Because those steep cuts have come at a time of rising concerns over future inflation, policymakers head into their Aug. 5 meeting sharply divided over where the Fed should go from here. A vocal minority will continue to angle for a rate hike, but the majority, led by Fed Chairman Ben Bernanke, will most likely prevail in holding the target rate at 2%.
It's increasingly clear that the Fed no longer has the leeway to raise rates without risking serious damage to the economy and the financial markets. Recent market turmoil amid troubles at mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE) has resulted in a fresh round of credit tightening that threatens to depress economic activity further. Based on futures contracts, investors only a month ago had expected up to three quarter-point rate increases by the end of the year, but they are now uncertain about the possibility of even one hike.
Although the Fed's patchwork of lending facilities has bolstered liquidity in short-term funding markets, its rate cuts have been largely ineffective at alleviating the broad constriction of credit, especially in housing. Despite the Fed's cuts totaling 2 1/4 percentage points since mid-January, fixed-mortgage rates are now a full point higher than they were then. Through June, sales of both new and existing homes had shown signs of stabilizing, and through May, monthly declines in house prices had been getting smaller. Now, higher mortgage rates have pushed housing affordability back down to the levels of last fall, and a new downturn in home demand, which would only prolong the slide in prices, seems likely.
As Bernanke told Congress on July 15: "Until the housing market, and particularly house prices, show clearer signs of stabilization, growth risks will remain to the downside." Bernanke knows that stronger home demand is needed to spur new building, shrink the inventory of unsold homes, and lift prices. Firmer prices are crucial to stemming mortgage defaults, rejuvenating the secondary mortgage market, and restoring the confidence in mortgage-backed securities needed to open the credit spigots more generally.
New risks to growth greatly weaken the inflation hawks' arguments for tighter policy. Their basic points have been that the Fed's target rate relative to inflation is the lowest since the early 1980s, and high energy costs threaten to feed expectations of inflation that could generate actual inflation. However, despite the Fed's low rate, pressure on bank balance sheets—stemming from huge writedowns of bad debt—is limiting banks' willingness to lend outside of housing and even to well-qualified borrowers. The credit markets are still tacking large risk premiums onto the borrowing rates of any company with less than a pristine credit rating.
Also, oil prices are down 15% from their peak, helping to reduce market measures of expected inflation. Bernanke recently qualified his inflation worries, saying he would need to see signs that expectations of higher inflation were becoming embedded in U.S. wage- and price-setting behavior before lifting rates. Given weaker job markets and slower wage growth, that comment sets a high bar for a rate hike.
The Fed's latest forecast, which was published before the most recent market upheaval, calls for growth of 1% to 1.6% this year. Given the first-half advance, that would imply a second-half pace between zero and 2%. And with tighter credit and weak labor markets, the downside risks to that somber outlook now appear to be greater than any upside risks to higher inflation. That's hardly a scenario for a rate hike, but it could be one for a rate cut.