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FEBRUARY 26, 2007
The Gray Area In The Fed's Blue-Sky Forecast Further rate increases may be needed to tame a spirited economy It has been said that monetary policy is a blunt instrument: Its overall impact on the economy is always difficult to gauge, especially since some sectors are more sensitive to interest-rate changes than others. That's why for more than a year the Federal Reserve has been tiptoeing around the housing sector, trying to beat down inflation without hitting the real estate market so hard that the whole economy falls. This year, though, housing will most likely begin to heal, even as the rest of the economy seems set to keep rolling along. This means the Fed will face a crucial decision: Will its current target interest rate of 5.25%, which worked so well to balance growth and inflation last year, be the right one to maintain that balance in the future? More to the point, it is not out of the question that the Fed will have to raise rates to assure that inflation recedes according to its plans. If the central bank's new forecast in its Monetary Policy Report to the Congress, presented on Capitol Hill by Chairman Ben S. Bernanke on Feb. 14-15, is on target, then investors needn't fret. Policymakers expect growth to slow in 2007 and hold at about that pace in 2008. They see labor markets loosening only a bit, with a slight rise in the unemployment rate this year, and they look for inflation to edge down in both 2007 and 2008. The trouble is, Fed forecasts tend to show the results policymakers would like to achieve, and they exclude the policy changes necessary to reach their goals. Right now, the economy is behaving more like one that's ready to pick up rather than slow down. Overall demand outside of housing grew faster in 2006 than it did in 2005, and consumers are off to a good start in January. As the drag from homebuilding fades, the underlying oomph in the rest of the economy will be felt more strongly. ONE REASON DEMAND REMAINS surprisingly robust might well be because monetary policy is a lot looser than you think. The Fed began lifting its policy rate from an unusually low level of 1% back in June, 2004, and by many measures, the current level of 5.25% represents financial conditions that are still accommodative to economic growth. Banks are more than willing to lend, and the credit markets see little risk in corporate borrowing. Long-term rates are low, and the dollar is relatively cheap in foreign exchange markets. Consider also that the Fed's real policy rate, or the rate adjusted for inflation, is still not very high compared to the peak levels reached in past episodes of Fed tightening. With the Fed's preferred inflation measure running at about 2.2%, the current real policy rate is about 3%. That's above the long-run average of 2.4%, which economists think is close to a neutral policy that neither stimulates nor restrains economic growth. IN THE FED'S TIGHTENING CYCLE in 1994-95, however, the real policy rate rose to just under 4%, a much more restrictive level, and in the 1999-2000 tightening it hit 5%. That level, if it had existed last year, would most likely have been overly constraining, given housing's vulnerability. But this year as the housing market stabilizes, the current real rate may not be restrictive enough to assure that the economy slows sufficiently to bring inflation back down into the Fed's comfort zone. 
At the same time, the impact of the Fed's latest series of interest-rate hikes is now wearing off. Fed policy actions operate with a lag generally thought to be about six to nine months. The last rate hike was in June, 2006, suggesting that by this spring whatever restrictive effects policy tightening is going to have will be fully incorporated into the economy.Even now, borrowing conditions, always a key by-product of Fed policy, don't appear to be restrictive at all, especially with long-term rates still low. The yield on 10-year Treasury notes is currently about 4.8%, compared to a peak of more than 6.5% during the 1999-2000 Fed tightening and more than 8% in the 1994-95 episode. According to the Fed's latest survey of senior loan officers at domestic and foreign banks, lenders sharply tightened their terms and conditions on mortgages to individuals in January, but standards on other consumer loans were generally about the same as a year ago. Banks said they eased terms on commercial and industrial loans to businesses, while credit standards on these loans had barely changed. Plus, a net majority of banks narrowed the spreads between their lending rates and the rates they pay to obtain funds, indicating banks are still aggressively competing for qualified borrowers. The same easy conditions are evident in the credit markets, For example, the rate on a 10-year, Standard & Poor's (MHP ) BBB-rated corporate bond, which is moderately risky but not speculative-grade, stood at 6.2% in mid-February. That's slightly lower than when the Fed began lifting its policy rate back in June, 2004. In addition, the market's assessment of the riskiness of that bond is also lower now than in June, 2004. The spread between the BBB corporate yield and a riskless 10-year Treasury note has barely widened. Cheap money with low risk: That's probably not what the Fed had in mind as a result of hikes in its policy rate totaling 4.25 percentage points. PERHAPS THE BIGGEST QUESTION MARK in the Fed's new forecast lies in the interplay between economic growth and the unemployment rate. Policymakers look for slower economic growth to open up only a slight bit of slack in the labor markets, a pattern they believe will be consistent with their goal for inflation to edge lower. However, if 2006 is a guide, it may not work out that way. Last year, the economy slowed, but, contrary to the Fed's expectations, the jobless rate continued to fall. Job markets were tighter at the end of the year than at the beginning, increasing the threat that labor costs could sharply outstrip productivity gains and put upward pressure on inflation. Unless growth this year comes in at the low end of the Fed's forecast range, job markets are likely to tighten even further, keeping the inflation threat from rising labor costs alive at a time when the Fed's price gauge is already higher than policymakers desire. 
Tight labor markets and the job growth they reflect are key factors behind the economy's strength: They are the biggest reason why consumer spending remains so resilient. January retail sales were held back by weak auto sales and gas station receipts that reflected lower gas prices. Excluding those two sectors, buying activity in the remaining 70% of retail sales showed strong momentum heading into 2007. In fact, real consumer spending this quarter stands a good chance to grow at a rate of 4% or better for the second quarter in a row. As long as the pace of consumer buying continues to beat expectations, it's likely the growth of the overall economy will do the same.The Fed has offered a picture-perfect forecast for 2007 and 2008. What's missing, though, is the level of interest rates needed to make it all happen. If the economy continues on its present course, that level may have to be higher than it is now.  By James C. Cooper
BW MALL
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