The Fed's Delicate Dilemma

Bernanke & Co. are being pulled in different directions by the economic data, so don't look for a rate cut—or rate hike—soon

by James Mehring

Note to investors: The Federal Reserve remains focused on inflation, so don't expect a rate cut anytime soon. However, given the recent weakness in economic data, a rate hike doesn't appear to be in the cards either. Indeed, with growth falling short of the Fed's outlook, and inflation remaining uncomfortably high, it appears the central bank may be on hold for a long while.

That was the message from Fed Chairman Ben Bernanke's Mar. 28 testimony before the Joint Economic Committee of Congress. Both Washington and Wall Street were interested to hear Bernanke's interpretation of the Federal Reserve's policy statement following the Fed's meeting on Mar. 21 (see BusinessWeek.com, 3/21/07, "Why the Fed Didn't Raise Interest Rates").

That statement created some confusion about which way the Fed was leaning on interest rates. His answer: Inflation is still concern No. 1, but the policymakers also have new concerns about the economy's outlook. In fact, "risks have increased on both sides," said the Fed chairman in response to a lawmaker's question. And when asked directly if the policy statement's new wording was meant to convey a move toward a neutral policy stance that might imply an increased inclination to cut rates, he said only that the statement was meant to give the Fed more flexibility in future decisions.

Conflicting Data

The testimony seemed to set the financial markets straight on where the Fed stands after last week's monetary policy press release. Back then, the stock market rallied sharply, as the Fed seemed to back away from its bias towards inflation and appeared to open the door to the possibility that it was inching closer toward cutting rates.

But on Mar. 28, the Standard & Poor's 500-stock index fell 0.8% on the day, after Bernanke suggested the door to rate cuts was not open as widely as the market previously thought.

The Fed's has an emerging dilemma—it is being pulled in two different directions by the economic data. The latest news on the economy has been generally on the soft side, but the slowdown that began last year, at least so far, has failed to bring inflation down the way the Fed would like.

Businesses Are Tightening Wallets

In his prepared remarks, the chairman stated that the economy looks set to keep growing at a moderate pace near 2% for the time being, but "as the inventory of unsold new homes is worked off, the drag from residential investment should wane." With expectations that consumers will keep spending, business will keep hiring, and capital spending will "post moderate gains," economic growth should improve.

However, the market also fell on Mar. 28 in response to signs that businesses are pulling back, not increasing, their capital spending. The February durable goods report showed that orders for capital goods outside of defense equipment and the volatile aircraft sector fell for the second straight month and for the fourth month in the past five.

With capital goods orders down 1.2% in February and at an annualized rate of 18.2% over the past three months, "we would call that a recession in the capital goods business, worthy of a Fed easing even if housing were not in a meltdown," says Ian Shepherdson, High Frequency Economics chief U.S. economist, in a Mar. 28 research note.

Hiring Resiliency?

Housing still appears to be on the ropes. On Mar. 27, Lennar (LEN), the country's third-largest home builder, scrapped its earnings forecast for 2007 and threw up its hands when it came to pinpointing when the housing market would begin to stabilize (see BusinessWeek.com, 3/27/07, "Lennar Report Adds to Homebuilders' Gloom"). In the first quarter, residential investment appears to have fallen by an annualized double-digit pace for a fourth straight quarter. Meanwhile, the continued deterioration in the level of housing permits shows that activity among home builders remain in retreat.

The weakness in housing and capital spending has yet to stop businesses from hiring. Strength in the labor market and the wage gains it's producing are a big reason why the Fed believes economic conditions will eventually improve. But if "employment follows capital spending down, then you have a real first-order problem for the economy," says JPMorgan Chase (JPM) economist Michael Feroli.

Unless, and until, that happens, the Fed will have to remain focused on price pressures. Chairman Bernanke made that clear in his Mar. 28 testimony by stating that "core inflation is above the levels most conducive to the achievement of sustainable growth and price stability," as he wrapped up his prepared remarks.

Less Is More

Right now, the Fed's preferred inflation gauge continues to linger above the 1% to 2% comfort level. The January core personal consumption expenditures price index, which excludes food and energy, was up 2.3% from a year ago, and economists expect it to have crept even higher in February. What's more, energy and commodity prices have picked up recently, providing little price relief for businesses and consumers.

So what's the Fed to do? Most likely nothing for the time being. Given that inflation shows few signs of cracking, Bernanke & Co. does not have the leeway to cut rates anytime soon without risking the loss of its inflation-fighting credibility. After all, the hardest part of the Fed's dual mandate of price stability and full employment is to keep inflation down, says Maury Harris, chief U.S. economist for UBS (UBS). And as long as the subprime mortgage collapse and worsening conditions in housing and capital spending are raising the risks to the Fed's economic growth forecast, a rate hike seems unlikely as well. Right now, about the only certainty in the outlook for monetary policy is a growing uncertainty.

Mehring is economics writer for BusinessWeek .