Fed's Dilemma

Tue. August 05, 2008; Posted: 05:03 AM

(RTTNews) - The Federal Reserve is scheduled to go through the motions of conducting its monetary policy meeting once again, and this time around, the markets are reconciled to the idea that it has no other options but to pause. Against the backdrop of surging commodity prices, is the central bank justified in doing so? Aren't the cumulative 325 basis point reductions handed out since September 2007 that saw the benchmark interest rates dip to 2% by April adequate to stimulate growth? Wouldn't no-action on August 5th render the rhetoric of a host of Fed speakers over the Fed's resolve of fighting inflation a farce? There are many unanswered questions as we turn our attention to today's FOMC meeting.

For starters, the central bank functions with the dual mandate of promoting effectively the goals of maximum sustainable employment and stable prices. The Fed achieves these objectives by manipulating the federal funds rate, which is the overnight lending banks charge each other, and adjusts the reserves in the banking system to move the federal funds rate to its target fed funds rate. If inflation overshoots, the benchmark interest rate is nudged up, which in turn pushes up long-term rates and curtails spending. On the other hand, when employment conditions deteriorate, rates are reduced.

Unlike the central banks of most other nations, the U.S. has never tried inflation targeting, which calls for an announcement that low and stable inflation is the overriding goal of monetary policy, and determination of a target range for inflation.

Inflation has become a contentious issue. The consumer price index rose at a monthly pace of 1.1% in June, the steepest increase since September 2005, while the core consumer price index rose 0.3%. Annually, the headline index was up 5.4% in June, its biggest increase since January 1991. The annual rate of core consumer prices, which has been consistently above the central bank target of 1%-2% since October 2007, was at 2.4% in June, though the measure was off its cycle peak of 2.7%.

June's personal income and outlays report showed a 0.8% month-over-month surge and a 4.1% annual increase in the PCE deflator, while the core PCE deflator rose 0.3% from the previous month and 2.3% from a year-ago. The annual rate of the core personal consumption expenditure index is clearly above the Fed's comfort zone of 1%-2%.

Meanwhile, the economy is going through a swoon. Standard & Poor's believes that a recession started in December 2007 and is expected to last until April 2009, which would make it 16 months long and equal the two longest recessions since the World War II in the mid 1070s and 1980s. The firm estimates that GDP will decline in the fourth quarter of 2008 and the first quarter of 2009 following which the economy is poised to see a slow recovery. However, one consolation is that most economists expect the recession to be shallow due to the concerted actions by the Fed and the government.

The Commerce Department revised down its estimates for fourth quarter GDP of 2007 to a small negative growth. Economists feel the contraction is too small and too brief too call a recession. The second-quarter GDP rose 1.9%, slower than the consensus estimate of 2.3%, but it was adequate to be termed a solid bounce back achieved on the back of the economic stimulus package.

The shortfall relative to the estimate was mainly due to a sharp retreat in inventory investment. Net exports contributed a solid 2.4 percentage points in the second quarter compared to 0.8 points in the first quarter. Housing investment declined by 15.6%, slower than the 25.1% drop in the previous quarter, and deducted 0.6 percentage points from growth.

The credit market tightening witnessed since the onset of the U.S. subprime mortgage market crisis and the subsequent credit crisis hasn't eased significantly. This was evident from a series of liquidity boosting measures announced by the Fed last week. The Fed extended the period for the Primary Dealer Credit Facility and the Terms Securities Lending Facility Through January 30th, 2009. The central bank also said it will introduce auctions of options on TSLF funding and a 3-month Term Auction Facility operations. Additionally, the Fed increased its swap line with the ECB to $55 billion from $50 billion. Economists point out the fact that these liquidity boosting-measures have complimented rather than substituted fed funds rate reductions despite them being more targeted liquidity measures.

What to Expect from August Meeting

The Fed is mostly likely to maintain its Fed funds target rate at 2%, as economic conditions continue to remain weak. Additionally, financial markets remain in a state of flux, thereby reducing the chances of monetary policy tightening even amid a surge in inflationary pressures. Two dissents are likely, mostly arguing in favor of an upward adjustment to interest rates. Lehman Brothers sees the dissents as reflecting the unusually high degree of uncertainty surrounding the economic outlook, rather than fundamental disagreements about monetary policy.

Federal Reserve Chairman Ben Bernanke said in his semiannual testimony on July 15th and 16th that downside risks to economic growth have increased and that upside risks to inflation have increased as well. The Chairman stressed that the "top priority" of the Fed is to help financial markets return to "more normal functioning." Despite Bernanke harping on downside risks to growth, some regional Fed Presidents who delivered public speeches in the inter-meeting period continued to emphasize their concerns over rising inflation.

Meanwhile, Wachovia Securities is of the view that we are closer to an interest rate cut than a rate increase. S&P also concurs with the view that the Fed has finished lowering rates, given the seriousness of inflation threat. However, the firm does not believes that the Fed will make changes to interest rates before the second quarter of 2009, as the central bank waits to see a let-up in inflationary pressures due to slowing global growth and wishes to see that the U.S. economic slowdown is clearly behind us. Additionally, the Fed may not like to take upon it the ignominy of playing politics by making any move during the Presidential election year.

The post-meeting policy statement is likely to be a fairly balanced statement, consistent with the fed funds target rate staying at 2%, pending more clarity. State Street Global Advisors expects the policy statement to tow in line with the past meeting's statement, while UBS' Maury Harris expects a more dovish/less hawkish message than in the June 25th statement. In June, the Fed acknowledged that the economic environment is fraught with risk. The Fed was of the view that inflation will moderate later this year and next, though believing that the upside risks to inflation and inflation expectations have increased.

The fact that the Fed changed its timeline for the moderation in inflation from 'the coming quarters' was perceived as a sort of confession that the central bank will not act hastily even if inflation surges in the coming months due to adverse base year effects. On growth, the apex body commented that the downside risks to growth appear to have diminished somewhat.

Global Interest Rate Scenario

Australia's central bank announced earlier today that it is holding interest rates unchanged at a 12-year high of 7.25%. However, the Reserve Bank of Australia signaled that it may reduce interest rates any time soon, as it acknowledged that the economy has weakened. Meanwhile, the Reserve Bank of India raised its repo rate by 50 basis points to 9% last week, while it also increased the cash reserve ratio by 25 basis points to 9%, as the developing economy of India is grappling with inflation. Across the Atlantic, the European Central Bank and the Bank of England are scheduled to meet this Thursday to chart out their respective near-term policy directions.

After holding interest rates steady for almost a year, the ECB was forced to ignore the slowing growth in the region and raise interest by 25 basis points to 4.25% to counter inflationary pressures. Economists do not see the possibility of more rate hikes this year. The Bank of England, which lowered rates by a total of 75 basis points between December 2007 and April 2008, raised rates to 5% in April and has held rates steady since then.

Future Direction of U.S. Fed Rates

Fed is less likely to tamper with rates this year, as inflation still remains an overwhelming concern. The price of oil remains a wild card, and could tilt the equation either way depending on which direction it takes. Crude oil has come off significantly from its recent highs around $145 a barrel, and yesterday it dipped below the $120-a-barrel mark, marking a near three-month low. The steady decline has been in reaction to hopes that slowing growth will temper global oil demand.

Although some stray economic reports do point towards resurgence in growth, there has been no concrete evidence of a definitive turnaround. Given the fragile labor market conditions and soft housing market, which is yet to truly bottom out despite the free fall it has been going through since the middle of 2005, and the lingering credit crisis, it only befits the Fed to wait and watch its monetary policy actions to take effect before it can go on a tightening mode to curb inflation.

That said, any further relaxation in rates could serve to worsen the inflationary environment and paint the Bernanke-led Fed in a bad light for having failed in their duty of keeping inflation under wraps. However, UBS looks forward a 50 basis point easing before the year-end, one 25 basis point reduction at the October meeting and another at the December meeting. The firm bases its prediction on the expectations that credit standards will continue to be tighter, growth will continue to stutter and unemployment rate with continue to rise alongside an ebbing of inflationary pressures under the impact of slowing growth.

The Fed has a tight rope to walk, as it attempts to draw on the strength and the astuteness of its team of economists led by Bernanke to help the economy avert a major downturn, while also ensuring conformance to its dual mandate.

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