Slower Growth Won't Stop Fed's Rate Increase: John M. Berry
Slower Growth Won't Stop Fed's Rate Increase: John M. Berry
April 20 (Bloomberg) -- For months Federal Reserve officials have been telling market participants to watch incoming economic data for clues about what likely lies ahead for monetary policy. The officials probably should have warned everyone not to jump to conclusions.
Certainly Fed officials themselves haven't seen convincing evidence that the U.S. economy is about to take the nosedive that some analysts have concluded has begun as a result of higher energy prices.
Moreover, the signs of slower growth, including relatively weak retail sales, a dip in manufacturing production and a hiccup in housing starts, won't deter Fed officials from raising their target for the overnight lending rate by another quarter- percentage point early next month.
Of course, Fed officials have made it abundantly clear that they will respond to changes in the outlook as necessary. Under the right circumstances the Fed could stop raising rates or even reverse course.
``The economy is likely to remain on a path of solid growth, strong enough to gradually reduce unemployment and raise operating rates in industry for a while,'' Fed Governor Donald L. Kohn said in a speech in San Francisco on April 14.
Kohn acknowledged that the persistence of higher energy prices ``may have a cumulating effect on spending, early hints of which might now be showing up in the latest reading on retail sales.'' Absent that, and some other restraining forces, such as a cooling housing market, growth would be even stronger, he said.
`Soft Patch'
As for interest rates, ``monetary policy is still accommodative and will need to tighten to avoid inflation building up -- the source of my 'for a while' prediction,'' Kohn said.
On Monday, his colleague on the Fed Board, Susan Schmidt Bies similarly told an audience in Buffalo, New York, that with ``accommodative financial conditions, I expect that the economy will continue to expand at a solid pace this year.''
At this point, Fed officials generally believe that healthy income gains will limit the damage to consumer spending from higher energy costs and strong business investment in new equipment and software will continue to bolster growth.
Meanwhile, all the talk about another economic ``soft patch'' hasn't deflected their concerns about inflation.
``Over time, both inflation and inflation expectations will be determined not by adjustments of particular prices but by fundamental factors -- the competitive environment in labor and product markets that in turn reflects the extent of resource utilization, and the pace of productivity growth and its effect on costs,'' Kohn said.
``The recent news on both fronts suggest that inflation pressures will remain contained, but substantial uncertainty surrounds that outlook,'' he noted.
Different Tune Possible
It is that uncertainty coupled with the still low level of the Fed's 2.75 percent target for the overnight lending rate relative to inflation that makes the officials, at least for now, determined to keep raising the target.
Should the dimensions of the current soft patch turn out to be much more significant and, as a result, inflationary pressures recede, Fed officials will sing a different tune. They would stop raising rates, and if need be, begin to cut them once again.
For one thing, none of the Fed policy makers appear in the least concerned about the specter of ``stagflation'' raised Monday by economist Paul Krugman of Princeton University in his column in the New York Times.
Krugman said the country is ``not back to the economic misery of the 1970s'' when it suffered from a serious case of stagflation -- a combination of high inflation and high unemployment. ``What few seem to have noticed, however, is that a mild form of stagflation -- rising inflation in an economy still well short of full employment -- has already arrived,'' he wrote.
Inflation Worries
The problem, of course, in the '70s was that with stagflation, the Fed had ``no good policy options. If the Fed cut interest rates to create jobs, it risked causing an inflationary spiral; if it raised interest rates to bring inflation down, it would further increase unemployment.''
Since the column appeared, numerous analysts have argued that Krugman is wrong, and he is. Aside from the levels of both joblessness and inflation, inflation fundamentals are completely different.
Inflation expectations are, to use Fed language, well anchored, and there is no wage-price spiral and productivity gains have been unusually strong -- as opposed to virtually non- existent as in the '70s.
The key point is that should economic growth really falter, there is every reason to believe that the inflationary pressures that have caught the eyes of Fed officials would diminish significantly. For instance, much slower growth in this country certainly would reduce world oil demand enough to bring down oil prices.
Meeting Objectives
And under those conditions, officials wouldn't face the dilemma their counterparts did three decades ago. Cutting rates would hardly add to inflationary pressures.
Kohn concluded his San Francisco speech this way:
``A time will come when we cannot provide guidance about our policy intentions because we ourselves will not be confident about the strategy that will be needed.''
And he added, ``In the meantime, all should understand that the guidance we do provide cannot and will not deflect us from changing our strategy whenever we believe doing so to be necessary to meet our objectives.''
Remember, those objectives include both stable prices and maximum sustained employment.
To contact the writer of this column: John M. Berry in Washington at jberry5@bloomberg.net.
To contact the editor responsible for this column: Bill Ahearn at bahearn@bloomberg.net.
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