Fed May Sacrifice Growth to Prevent Inflation (Update1)
Fed May Sacrifice Growth to Prevent Inflation
Sept. 21 (Bloomberg) -- Federal Reserve policy makers may be willing to sacrifice economic growth if that helps them keep inflation under control as energy prices soar, economists said after reading the central bank's latest statement.
``This is not a policy of indifference,'' said David Resler, chief economist at Nomura Securities International in New York. ``This is a policy of additional restraint. Contrary to what they say, they think the inflation threat is graver than the threat to growth.''
The Fed raised its benchmark U.S. interest rate a quarter- point to 3.75 percent yesterday, the 11th straight increase since June 2004. The U.S. faces only a near-term setback from Hurricane Katrina instead of a ``persistent threat,'' the central bankers said after meeting in Washington. The rate increase and the statement's tone show the Fed's foremost concern is preventing faster inflation, economists said.
``When push comes to shove, the Fed will opt in an unmistakable fashion to preserve the inflation achievements they have,'' said Anthony Karydakis, chief U.S. economist at J.P. Morgan Asset Management. ``They will be very willing to sacrifice some growth for a while to keep inflation under control.''
That's a break from the way the Chairman Alan Greenspan and other Federal Open Market Committee members handled rising energy prices in the past, former Vice Chairman Alan Blinder said.
Keeping Pace
The Fed previously tried to ``cushion the blow to the real economy by being easier with monetary policy, not tighter,'' when there were temporary oil price increases, said Blinder, now an economics professor at Princeton University. ``In this case, he was not easier with monetary policy. It looks like a small, sliding away from that previous tradition.''
Oil prices jumped 31 percent from January through March, and the 12-month rate on the so-called core consumer price index rose to 2.4 percent in February, the highest reading this year. To help keep the economy growing at a robust 3.8 percent annual rate that quarter, the Fed didn't change its ``measured'' pace of tightening to a more aggressive strategy, even though its policy rate declined in inflation-adjusted terms in March.
``The Greenspan standard,'' Blinder wrote in a paper with Princeton economist Ricardo Reis earlier this year, is to avoid the ``error of piling tight money on top of an adverse oil shock -- which is a pretty sure recipe for recession.''
Risks to Strategy
Now, economists noted, the Fed's own forecast is calling for a temporary slowdown in production, hiring, and spending and interest rates are moving higher. In effect, the central bank is raising rates into a downturn, hoping to re-establish a trend of low inflation.
The Fed's decision has already boosted traders' expectations of more restrictive rates going forward. Futures prices now show traders see a chance the central bank will raise the benchmark overnight lending rate at both the November and December meetings. Prior to yesterday's increase, they predicted the Fed would raise rates only one more time this year.
The yield on the December federal funds futures at the Chicago Board of Trade rose 6 basis points yesterday to 4.02 percent.
Economist Resler says the Fed's strategy may be risky.
``They are paid to worry about inflation, that is their job,'' Resler said. ``They are also paid not to ignore threats to the downside, or to understate them, which is what I think they are doing.''
Growth Forecasts
The FOMC has been raising the rate target in the context of robust growth in output, a falling unemployment rate and low inflation as measured by so-called core price indexes that exclude food and energy costs. The rate is now the highest since August 2001, a month before the terror attacks on Washington and New York.
Following Hurricane Katrina, which slammed into New Orleans and Gulf coast cities Aug. 29, economists slashed their estimates for growth and raised their estimates for inflation.
Prior to the hurricane, economists expected the economy to grow 4.1 percent in the third quarter, according to the median estimate in a Bloomberg News survey. They now expect growth of 3.6 percent.
The Fed's statement suggested the downturn in growth and employment wouldn't ``persist.'' The language used to describe energy prices avoided descriptions that might have suggested the threats to inflation were temporary.
``Higher energy and other costs have the potential to add to inflation pressures,'' the Fed said.
Inflation Expectations
``There is something else going on that points to them being much more concerned about the inflationary impact'' of rising energy prices, said Michael Woodford, a co-director of the Program for Economic Research at Columbia University in New York who has advised the Fed Board.
That ``something else'' could be the possibility that what economists call inflation expectations, or consumer and business instincts about where prices are headed, could become unleashed in the wake of the large billboard effects of rising fuel prices.
The average retail price of gasoline is up 55 percent year-to- date. One year inflation expectations, measured by a University of Michigan survey, a set of data the Fed has watched in the past, rose to 4.6 percent in preliminary September report from 3.1 percent a month earlier.
``Hardly a day goes by without seeing fairly credible anecdotal reports about price increases in various industries,'' said Karydakis. ``This is the first time in a very large number of years they are confronted with mounting inflation pressures.''
Greenspan ``doesn't want to leave behind a legacy of an upward creep in inflation.''
To contact the reporter on this story: Craig Torres in Washington at ctorres3@bloomberg.net
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