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Fed’s latest slice signals a pause, but statement shows it’s unsure about next step

The statement announcing the United States Federal Reserve’s interest-rate cut on Wednesday shows a policy-making body caught between conflicting forces and playing for time.

Fed chairman Ben Bernanke and his colleagues surprised no one when they cut their overnight target rate by a quarter of a percentage point, to 2 per cent, the lowest level since November 2004.

The policy statement seemed to suggest that officials are moving to the sidelines to take stock of the impact of 3.25 percentage points worth of rate cuts since last September, coupled with the launch of a number of programmes aimed at improving credit market conditions.

The central bankers signalled this pause by stating that “the substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help promote moderate growth over time and mitigate risks to economic activity”.

But it was the Fed’s assessments of prevailing economic conditions that showed the central bank’s challenges. The institution deemed economic activity as “weak” and noted that financial markets “remain under considerable stress”. And that assessment seems to make a case for more rate cuts.

But the Fed’s anxieties about inflation make it wary of lowering rates further. The central bankers flagged a deterioration in expectations of future inflation and said that “uncertainty about the inflation outlook remains high”.

Policy-makers have long held the view that slowing growth will quell price gains, but much of that forecast has rested on the often-unreliable expectations that energy and commodity prices will begin to moderate.

This conflict between forces arguing for and against rate cuts is evident also in the voting patterns of the policy-making Federal Open Market Committee (FOMC) in the past two meetings. During both occasions, the presidents of the Philadelphia and Dallas Feds have opposed the rate-cut decisions out of concern for inflation - further evidence of the unsettled state of affairs.

“It’s clear that the Fed, by moving a quarter point with two dissents and more concerns about inflation - I suppose there is some sense that the Fed is nearing a bottom” on rate cuts, if it hasn’t already, said Mr Marvin Goodfriend, an economics professor at the Tepper School of Business at Carnegie Mellon. Mr Goodfriend has also served as a top staffer at the Richmond Fed.

He said that based on the Fed’s current views on the growth and inflation, “there is no question that this statement is a little schizophrenic”, as policy-makers struggle to manage the twin forces.

Mr Carl Riccadonna, an economist with Deutsche Bank, agreed that the Fed signalled its inclination to hold rates steady for a time, even though his bank believes the economy will force policy-makers to cut again at their June gathering.

But he rapped the Fed for having “befuddled people” by not signalling more overtly that they are not inclined to cut again.

Mr Riccadonna argued that most policy statements, which are the Fed’s usual method of signalling the likely future path of rates, clearly characterise the risks to growth. That risk assessment typically shows up in FOMC statements, but not this time.

As things stand, most private-sector economists appear a touch more pessimistic than the Fed on growth. The forecasters expect that events will cause the Fed to cut rates again at some point in the later half of the year.

But inflation problems are likely to continue to bedevil policy-makers. While the Fed is on solid ground in arguing that core inflation remains relatively contained, there are ample reasons to suggest that may not always be so, especially given how accommodative the rate policy is now.

Last Friday’s release of the Reuters/University of Michigan April consumer sentiment survey showed a real deterioration in the public’s view of where inflation is headed.

A report on Tuesday by the Conference Board said: “Consumers’ inflation expectations continue to rise and this measure now matches the all-time high reached in the aftermath of Hurricane Katrina.”

Overall, gauges of inflation are rising and market-based measures have moved in unfavourable directions. Inflation fears are largely rooted in surging energy prices. The Fed has little ability to control these price rises, which are beginning to bleed into other parts of the economy.

The jump in energy prices is also playing a notable role in rising food prices, which have in turn been joined by ominous overseas shortages and anecdotal reports in the US of the shortfalls of staple goods.

What is more worrying is that rising inflation is not contained within the US. The Organisation for Economic Cooperation and Development reported on Tuesday that consumer prices were up by 3.5 per cent in member nations, from 3.4 per cent in February.

Eventually, food and energy price gains filter their way into the core prices that Fed officials focus on. Decent productivity rates and a willingness to surrender profit margins cannot offset all of that pass-through.

The Fed has difficult choices ahead of it. - Dow Jones

Source : Today - 2 May 2008