The Fed Won't Give The Markets A Break

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Sharply tighter credit conditions in the mortgage market will lead to more foreclosures and add to the already heavy inventory of unsold homes, putting further downward pressure on prices. That, plus a possible negative wealth effect from falling stock prices, could weigh on consumer spending. Outlays by businesses for new capital projects and inventories are also in danger of slowing, given that credit-market funds are more costly, that banks are likely to tighten their lending standards, and that heightened uncertainty now pervades the outlook.

Only a month ago, some economists expected the Fed to hike interest rates by yearend. That scenario is out the window. Higher rates would only increase the chances of a credit crunch and deepen the housing slump. The threat of a crunch will keep the Fed on hold indefinitely, and the chance of rate cuts is much higher.

IN FACT, THE BERNANKE FED may soon face a crucial question it has not yet had to deal with: If the Fed feels the need to cut rates, will it act fast enough and with sufficient preemption to avoid a recession? Preemption was uppermost in the Greenspan Fed's strategy, but its role in Bernanke's Fed has yet to be defined.

In some ways, the market turmoil is playing right into the Fed's hands. If the volatility represents simply a readjusting of attitudes toward risk and nothing more pernicious, then it will be equivalent to a tightening of monetary policy, providing a deterrent against future inflation. Still, the Fed's biggest inflation worry stems from the tightness in the labor markets, and until wage and price pressures visibly ease there, inflation will remain the Fed's top concern.

On the surface, the Labor Dept.'s July employment report looked Fed-friendly. Payrolls grew by only 92,000 from June, and the unemployment rate rose to 4.6%, from 4.5%, suggesting some easing in job market pressures. But government jobs fell sharply because of a seasonal quirk in teacher payrolls. Do the math, and private sector employment rose by 120,000 jobs, exactly equal to the healthy monthly pace for the entire year.

Also, the inflation implications of the latest productivity numbers are hardly upbeat. Labor Dept. revisions going back three years show an even steeper slowdown in productivity growth in recent years than the early data had revealed. They also show unit labor costs--pay and benefits offset by productivity gains--have accelerated sharply, to the fastest annual clip in nearly seven years. That speedup puts added pressure on business to raise prices.

Buffeted by the crosswinds of credit tightening and inflation worries, the Fed's decisions in the coming months promise to be the most crucial in Bernanke's 18-month tenure. For now, all the Fed can do is wait and try to judge which wind is blowing the hardest.

Cooper is BusinessWeek's senior editor and senior economist and writes the influential “Business Outlook” column.