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Fed to Focus on Clouds in Forecast,

Though Core Inflation Has Eased
With Unemployment Low,
Officials May Emphasize
Risk Factors in Outlook
By GREG IP
June 21, 2007; Page A3



WASHINGTON -- With inflation soon likely to drop into the Federal Reserve's so-called comfort zone of 1% to 2%, Fed officials are seeking to shift their emphasis away from today's benign inflation readings to the more uncertain path of future inflation.

To that end, the central bank's policy makers, when they meet next Wednesday and Thursday, are likely to continue to highlight the risks that low unemployment could yet push inflation higher.

.....• The Scenario: Fed policy makers meet next week with inflation nearing their "comfort zone" of 1% to 2% but are expected to shift their emphasis to future inflation.
.....• The Debate: The Fed still sees risks of inflation rising but is less certain that the current inflation rate can be described as "elevated."
.....• What It Means: Lower inflation makes an eventual increase in the Fed's target for short-term interest rates, now 5.25%, less likely.

At next week's meeting, Fed officials are expected to debate whether to continue describing inflation as "elevated" in their post-meeting policy statement, an issue complicated by their lack of consensus on whether inflation ought to be much lower than it already is.

There is little chance the Fed will alter its target for short-term interest rates, which has stood at 5.25% since last summer. Officials appear on hold for at least the next several months.

Inflation alarms sounded at the Fed when the annual pace of core inflation, which excludes food and energy prices, jumped to 2.4% in February from 2.1% in December, as measured by the Fed's preferred inflation gauge -- the price index for personal consumption expenditures. The jump prompted officials to describe inflation as "elevated" following their March and May meetings.

But core inflation has since dropped back to 2%, and data to be released June 29, the day after the Fed meeting ends, are expected to show it falling to 1.9% in May. The Fed doesn't think this decline is a quirk.

Dropping the word "elevated," which did disappear temporarily from the Fed's statement in January, may stir up some opposition within the Fed. Several officials, taking their cues from a proposal by Ben Bernanke in 2002 when he was being confirmed as a Fed governor, have said their inflation comfort zone is from 1% to 2%. Federal Reserve Bank of Chicago President Michael Moskow last week reiterated that he prefers inflation at about 1.5%, the midpoint of his 1% to 2% comfort zone. By that criteria, the current inflation rate is still too high.

But only a handful of officials still publicly back that range. Other officials, including Mr. Bernanke, no longer cite it. Several others never agreed with it. There's no simple way to clarify this for the public; the Fed itself is engaged in a lengthy internal discussion of communications strategy. The European Central Bank, in contrast, has a public goal of keeping inflation "below, but close to, 2% over the medium term."

Despite the talk of an inflation comfort zone, Mr. Bernanke has long preferred that the Fed and public focus on forecasts of inflation and economic growth. By that criterion, whether the latest inflation rate changes by 0.1 percentage point matters less than where it will be in a year, and how confident the Fed is in that forecast.

On that score, the Fed is still worried about inflation going higher, though less so than a few months ago. Mr. Moskow said last week that inflation had dropped "a little bit more quickly" than expected. And yesterday, Richard Fisher, president of the Dallas Fed, said "there are some encouraging signs" on inflation, "but we are not there yet."

In their February forecast, Fed officials said they expected core inflation to end the year between 2% and 2.25% and drop into the 1.75% to 2% range by the end of 2008.

Core inflation rose in early 2006, mostly as companies passed higher energy costs through to consumers in the form of higher prices for goods and services, and as rising home prices prompted more people to rent apartments, driving up "owner's-equivalent rent," a proxy for the cost of homeownership.



The increase in housing costs has since slowed as the rising supply of vacant homes restrains rents. The recent rebound in energy prices isn't expected to add much new pressure to core prices because they haven't exceeded last year's peaks.

But the Fed does still see risks of higher inflation from the lack of spare capacity in the economy, which means higher demand is more likely to translate into higher prices and wages. Despite a year of slow growth, the unemployment rate, at 4.5%, remains near a six-year low. Global growth is robust, boosting demand for U.S. exports.

In this environment, the Fed is still likely to express some concern that its forecast for inflation to moderate, dropping below 2% by the end of 2008, might go off track.

Despite indications the nation's economy has bounced back from a first-quarter slowdown, the Fed for now is sticking to a forecast of modest growth this year, principally because the housing market is taking longer to hit bottom than the central bank previously expected. Indeed, the recent rise in mortgage rates modestly boosts the risks to the housing market.

The Fed is unlikely to overhaul the structure of its end-of-meeting public statement until it finishes an internal debate over communications. Officials remain divided over the merits of an inflation target and may delay any decision on it until next year. But there is less resistance to the notion of more frequent and detailed forecasts.

Officials are likely to spend a lot of next week's two-day meeting discussing both issues. A few weeks later, Mr. Bernanke will deliver updated forecasts of growth and inflation to Congress, providing him with an opportunity to shift the focus from today's inflation rate to next year's.

Write to Greg Ip at [e-mail]