Fed Seeks Clues to Stop Increases as Rates Approach `Neutral'
Fed Seeks Clues to Stop Increases as Rates Approach `Neutral'
July 19 (Bloomberg) -- The Federal Reserve is entering a new phase in its drive to bring interest rates back up to normal: While the central bank will continue to push rates higher, policy makers also will watch for signs that it may be time to stop.
Former Fed Governor Laurence Meyer says the Fed is approaching the ``lower boundary'' of the so-called ``neutral'' zone where it hopes to leave the benchmark overnight lending rate -- a point at which monetary policy neither slows economic growth nor stimulates it, intensifying inflationary pressures.
Fed Chairman Alan Greenspan is expected to say tomorrow in his semi-annual report to the House Financial Services Committee that the Fed will continue to raise rates at a ``measured'' pace. Greenspan gave no hint of any pause in the central bank's rate- raising push when he testified before Congress June 9.
``They are feeling their way toward neutral,'' said Brian Sack, a senior economist in Washington at Macroeconomic Advisers, the St. Louis-based forecasting firm co-founded by Meyer. ``They are willing to let the data tell them whether they have removed accommodation.''
While Fed officials themselves haven't set boundaries for what constitutes a neutral rate, private economists estimate it's somewhere between 3.5 percent and 4.5 percent, Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, said in a speech July 8 without disputing that appraisal.
``It is an amorphous concept,'' Greenspan said during a question-and-answer period after a speech to the New York Economic Club on May 20. ``You get to the point that we will not know it until we are actually there, and maybe we will miss it.''
August Meeting
The central bank's policy-setting Federal Open Market Committee raised the federal funds rate to 3.25 percent on June 30 and is expected to push the benchmark overnight lending rate to 3.5 percent at its next meeting, on August 9. The panel also is scheduled to meet in September, November and December.
``The task here is to move the interest rate back to a more neutral level without dampening growth in real output, but it is essential for us to ensure our goal of long-term price stability,'' Anthony M. Santomero, president of the Federal Reserve Bank of Philadelphia, said in a speech July 13.
``The precise course the Fed takes will very much depend on the precise course the economy takes,'' Santomero said. ``We all have our own lists of risks to the outlook that may alter the economy's course. These must be monitored over the remainder of the year, and no doubt they will play an important role in determining the course of actual policy.''
The median forecast in a Bloomberg News survey of 65 economists taken between June 30 and July 11 indicates the federal funds rate will reach 4 percent by the end of this year, a quarter-point higher than the forecast in the previous survey.
``We are coming into the third quarter with a lot of momentum and a low unemployment rate that will compel the Fed to raise the overnight rate to 4 percent by year-end,'' said Sack of Macroeconomic Advisers.
Eyes Open Wider
Former governor Meyer calls the new phase the ``open-your- eyes-even-wider-and-feel-your-way-to-neutral'' approach to rate- raising. The Fed began raising rates in June 2004 when the federal funds rate was at a 45-year low of 1 percent after the central bank slashed interest rates to combat the recession.
That doesn't mean that the Fed is likely to stop its rate- raising anytime soon, said Roger Kubarych, a former Fed economist who is now a senior economic adviser at HVB America Inc. in New York. He and Meyer both predict the federal funds rate will reach 4 percent by year-end. The implied yield on the December federal funds contract was 3.965 percent yesterday, indicating traders expect three more quarter-point increases in the benchmark interest rate by the end of the year.
Coping
The Fed ignored weaker economic data from April and May and raised rates in June without any hint that it planned to pause, a sign that its internal forecast calls for continued strong economic growth. Greenspan, in a letter yesterday to the chairman of Congress's Joint Economic Committee, said the economy is ``coping pretty well'' with rising energy prices and that statistical models point to ``continued moderate expansion of GDP for the foreseeable future.''
``It's still too early to be foreseeing a pause,'' Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, said to reporters July 11 after a speech. ``I'm comfortable with the `measured pace' characterization right now'' -- referring to a gradual rise in interest rates.
Former Fed Governor Lyle Gramley, now a senior economic adviser at Stanford Washington Research Group, said that while the Fed is still leaning toward more rate increases, ``it's not automatic at this point.''
``The mode the Fed is in now is not `Why should we raise interest rates?' but, `Why shouldn't we raise interest rates?''' he said.
Disengaging the Autopilot
Economic reports last week show that ``inflation is benign, growth is good and that the Fed does not have a lot more to do,'' said James Glassman, senior U.S. economist at JP Morgan Securities Inc. in New York. ``It suggests that the case is building for the Fed to disengage its autopilot, to take a pause and skip some meetings.''
Gramley said he believes ``the economy is probably growing a bit too fast for comfort.'' Last week's figures show that second- quarter economic growth probably will be in the range of 3.75 percent, almost as much as the 3.8 percent recorded in the first two months of this year, Gramley said. ``I think the Fed would rather see something in the range of 3.5 percent.''
Richard Berner, chief U.S. economist at Morgan Stanley & Co. in New York, predicted in a July 11 letter to clients that the economy was ``poised to resume a stronger tempo'' in the second half of the year, probably accelerating to a 3.7 percent pace in the third quarter and 4.2 percent in the fourth.
Economists including Berner estimate that U.S. economic growth slowed to about 3 percent in the second quarter.
Inflation Risks
``A return to above-trend growth, the firming in both labor and product markets and slower productivity gains hint at upside inflation risks,'' Berner said. ``Further measured tightening'' by the Fed is likely, he said, ``and an improving economy will delay any pause in the Fed's tightening campaign.''
David Rosenberg, chief U.S. economist at Merrill Lynch & Co. in New York, is less optimistic, predicting that the U.S. economy will grow by 2.7 percent in the third quarter and 3 percent in the fourth, partly because the Fed's continued drive to raise interest rates is helping to slow growth.
``The slowdown in U.S. economic growth is upon us and will frame the economic outlook for the next several quarters and allow the Fed to move to the sidelines after August,'' Rosenberg wrote in a July 8 letter to clients. ``We believe the Fed should ease up on the tightening reins as policy is close to neutral.''
To contact the reporters on this story: Art Pine in Washington at apine@Bloomberg.net; Craig Torres in Washington at ctorres3@bloomberg.net
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