The Great Risk Shift
Why Oh Why Can't We Have a Better Press Corps?

Fed Policy Is Still Data-Dependent

Greg Ip:

Why Fed Might Keep Rates on Hold Longer Today Than It Did in 1995 - Core inflation has since risen to 2.9%, according to last week's report on September's consumer-price index; it's a bit lower using the Fed's preferred-price index. Though the Fed has no official target for inflation, Mr. Bernanke and many of his colleagues have often suggested a ceiling of about 2%, and all agree today's rate is too high. Still, most investors expect the Fed to leave short-term rates unchanged at 5.25% at its policy meeting tomorrow and Wednesday.

Having known price stability, and then lost it, today's Fed is under added pressure to regain it. But Mr. Bernanke doesn't intend to restore price stability immediately regardless of the cost in terms of jobs. His central forecast is that as energy prices retreat, so will their indirect impact on core inflation, bringing the core rate back to around 2% by 2008. Yet the Fed is still counting on some slowing in economic growth to bring that about. That is one reason it is not alarmed, and is indeed pleased, that since June, annualized growth has probably slipped below 2.5% and is expected to continue at that rate through mid-2007.

"The economy appears to have entered a period of below-trend growth," San Francisco Federal Reserve Bank President Janet Yellen said last week. As long as that continues, it will "gradually...reverse any underlying inflationary pressures." Rather than "opportunistic disinflation," the Fed's current strategy could be called "deliberate disinflation."

A steeper slowdown or looming recession would probably prompt the Fed to shift its attention to growth from inflation, and thus to cut rates. Fed officials are aware that 2006 has parallels not just to 1995 but to 2000. In 2000, as now, strong growth had been fueled by strong investment -- business then, residential now -- and related asset prices -- stocks then, home prices now.

In 2000, Fed officials last raised rates in May, then maintained a public bias toward higher rates for seven months as, privately, their inflation worries receded and growth worries grew. In part, they feared a premature shift to easier monetary policy would reinflate the stock bubble. In retrospect, the Fed didn't realize how far tech investment would fall, undermining the entire economy. Though officials today believe housing isn't like the Nasdaq Stock Market was in 2000, they keep an open mind.

Uncertainty about housing is a major reason the Fed paused when it did in its rate-raising campaign, and that creates another distinction. Even adjusted for inflation, short-term interest rates, which the Fed controls directly, are lower now than at the same point in either the 1995 or 2000 cycles, and long-term rates are even lower.

Treasury-bond yields, minus consumers' long-term expected inflation rate, are just 1.7%, compared with 2.8% in September 2000 and 3.4% in May 1995. "Financial conditions remain quite supportive of borrowing and spending," Fed Vice Chairman Donald Kohn said three weeks ago. "Market interest rates are not high."

Fed officials still debate why long-term rates are so low. It may reflect pessimism about long-term economic growth and investment prospects world-wide, and so give the Fed a reason to worry less about inflation and more about growth. Nonetheless, moderate rates make it harder to argue monetary policy is especially tight right now -- and thus, make the case for rate cuts less compelling.