Interest Rate Tightening: It's All in the Timing

Despite the 3 1/2-foot snowfall that shuttered Congress, Federal Reserve Chairman Ben Bernanke managed to grab headlines on Feb. 10 when he delivered testimony on the central bank's "exit strategy" to the snowbound lawmakers via e-mail. Bernanke's 11-page exegesis on unwinding the Fed's ultra-easy monetary policy and ultimately raising interest rates was filled with plenty of detail on the "how." But when lawmakers query Bernanke in person, during the Fed's semiannual economic report to Congress on Feb. 24, their biggest question will be: "When?"

That's no surprise, given that this is an election year, with embattled Democrats fighting to retain control of Congress. During his testimony, Bernanke is sure to resist anything that looks like a timetable for tightening. In the end, though, he may be able to give lawmakers what they really want—steady interest rates until after the fall elections—provided he gets a little help, from both China and Congress itself.

It's a toss-up as to whether the Fed raises rates ahead of the election, according to Feb. 16 prices on the Chicago futures markets. Traders peg the chance of a rate hike at the Fed's Sept. 21 meeting at a bit under 50%. The odds of a move at the central bank's subsequent meeting, however, jump to about 2 in 3. It's easy to see why: The meeting is scheduled to end the day after Americans go to the polls.

Since last March, the Fed's mantra on interest rate policy has been simple and consistent: The short-term rates it controls are likely to remain "exceptionally low" for an "extended period." Bernanke reiterated that in his Feb. 10 virtual testimony and is likely to repeat it again on Capitol Hill next week. Many in the financial markets see that as tantamount to a promise not to raise the rate from its current near-zero level for six months.

Fed leaders are quick to point out that their commitment on rates depends on the amount of slack and price pressures in the economy and expectations of future inflation. If those change, policymakers feel they are free to do what they want with rates.

The unemployment rate is perhaps the best proxy for how much economic slack there is right now. While its drop to 9.7% last month surprised economists inside and outside the Fed, that's still a long way from the roughly 5% level that policymakers consider as meeting their congressionally mandated goal of full employment.

That suggests there's no need for the Fed to worry about wage-driven inflation soon. In fact, employers' labor costs, including pensions and other benefits, rose at an annual rate of just 1.5% in the fourth quarter of 2009.

What price pressures there are in the economy reside in goods, not labor-intensive services. Prices on everything from gasoline to clothing rose at an annual rate of 5.8% in December, more than double the 2.8% increase in the overall consumer price index (of which goods are a component).

This is where China could provide some help to Bernanke. Surging Chinese demand drove global commodity prices about 50% higher last year, contributing to the rise in goods prices in the U.S. If Beijing succeeds in its recently launched efforts to cool its economy, that will restrain the rise in commodity prices—and take pressure off the Fed to raise interest rates.

Bernanke is doing his part to keep inflation fears tamped down by continually talking about tools the Fed has for managing its bloated balance sheet (up 165% since 2007) and removing all that liquidity from the economy. But he could use some help from Congress in getting that message across.

Some investors fear political pressure will keep the Fed from tightening credit in time to keep inflation at bay. A nagging concern: a bid by Representative Ron Paul (R-Tex.) to subject Fed monetary moves to second-guessing by Congress' Government Accountability Office. A quick decision to quash the proposal would help ease investors' inflation fears. That in turn would give the Fed more latitude to keep interest rates low—and lawmakers happy.

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