Treasury yields sharply lower across the maturity spectrum. Now most analysts have seen the light. Yields, while still low, are heading up again, and stock investors seem happy in the belief that maybe the Fed will be on hold for quite a while.
Fed policymakers did little to dispel that belief at their Oct. 24-25 meeting. In fact, judging by the Fed's decision to keep its target rate at 5.25% for the third consecutive meeting, the Fed seems to believe patience is a virtue. Although inflation outside of energy and food is running above the central bank's 1%-to-2% comfort zone, the economy's slower pace in the middle two quarters of 2006 gives policymakers reason to wait for price pressures to ease in the coming year.
However, investors beware. Several factors are coming together that could cause the Fed's patience to wear thin. By the Fed's own accounting, there is not as much slack in the economy as its policymakers saw only a few months ago. That means the economy has less room to grow without putting added pressure on inflation. Further complicating that issue, the economy appears to be regaining some momentum in the current quarter, especially from faster consumer spending. The new risk: Inflation could remain stubborn enough to provoke the Fed into raising rates sometime next year.
For now, the markets are taking the Fed at its word --and its forecast. The policymakers' statement after the Oct. 25 decision highlighted the Fed's belief that "the economy seems likely to expand at a moderate pace" and that "inflation pressures seem likely to moderate over time." But at the same time, the Fed made clear that it continues to believe the risk of higher inflation is greater than the risk of a weak economy. That means any future policy action is biased toward raising rates, not holding them steady, and certainly not toward lowering them.THE NEW FACTOR in Fed policy is the revival of an old debate, last joined in the late 1990s: What is the economy's noninflationary "speed limit," or the growth rate over the long run that allows the economy to make full, but not excessive, use of its resources? The question is important because if, at any given time, the economy is not fully utilizing all of its available workers and production facilities, then inflation pressure can ease. However, as that gap between actual and full utilization closes, it becomes much harder for inflation to slow.
The new focus on the issue came to light in the minutes of the previous Fed meeting on Sept. 20. They said the Fed's research staff had lowered its estimate of the speed limit for the second time in as many meetings. Those downgrades reflected the government's recent downward revision of real gross domestic product from 2003 to 2005, and the upward refiguring of job growth from March, 2005, to March, 2006. That combination has cut into productivity growth, the most important factor in the economy's noninflationary growth limit.As a result, the researchers concluded, the Fed's forecast for growth in the coming quarters "was consistent with an opening of only a small gap in resource utilization." In plain English: Inflation might be very slow to ease, and if the economy's growth rate exceeds the Fed's forecast, inflation might even rise further. Many private economists believe, even if the Fed's forecast for "moderate" growth holds, more than "only a small gap" between actual and full resource use will have to open if inflation is to drift lower.ALL THIS MAKES the economy's future growth rate paramount in figuring out what to expect from Fed policy over the next several months. Analysts who still believe the Fed will start cutting rates sometime next year expect a soft economy. Those who look for further hikes think the economy is percolating nicely.
So what's the Fed's view? The policymakers' most recent forecast, released back in July, implied growth in the second half of 2006 would slow, from about 4% in the first half, to about 2.5%, with the pace picking up a bit to the 3%-to-3.25% range during 2007. Although growth did slow significantly in the third quarter, the new development is the economy's apparent reacceleration in the fourth quarter, to a pace most likely faster than what the Fed has been expecting.
That speedup is partly a result of plunging energy prices, which are having an uplifting effect on consumer purchasing power and corporate spending plans. Earlier this year, rising energy prices had been one of the Fed's inflation concerns, to the extent that companies might be expected to pass along higher fuel costs in the prices of their products. However, costlier energy was also a headwind that helped to slow economic growth. Now, cheaper energy has turned into a tailwind.
Faster economic growth could make the Fed's expectation of lower inflation that much tougher to achieve, especially given the economy's lower speed limit. Right now, policymakers expect their preferred measure of core inflation, which excludes energy and food, to end 2006 in the 2.25%-to-2.5% range, before slipping to the 2%-to-2.25% band by yearend 2007. However, by August, yearly core inflation had already picked up to 2.5%. That's the top end of the Fed's forecast range, and a half-point above its stated comfort zone.PERHAPS THE MOST IMPORTANT question policymakers will grapple with in coming months is this: Is a 5.25% target rate restrictive enough to keep the economy from outgrowing its available labor and production facilities? That is, will current policy keep the economy from overheating? After all, the unemployment rate is already at a five-year low of 4.6%, and the percentage of industrial output capacity in use has stayed above its long-run average of 81% almost all year.In fact, despite the Fed's 17 quarter-point rate increases since June, 2004, nearly all signals point to financial conditions that are still very accommodating to growth. Unlike during past episodes of Fed rate-hiking, banks were still easing their lending standards this past summer, and the narrow spread between yields on corporate bonds and Treasury notes implies the credit markets see little risk in lending.
In addition, the Fed's real policy rate, the rate adjusted for inflation, currently stands at only about 2.8%, just slightly above the long-run average of 2.4%. During the tightening cycles of 1995 and 2000, the real policy rate peaked at 3.8% and 5%, respectively. By that metric, policy remains easy compared with past episodes.
For now, Wall Street seems to be buying the Goldilocks scenario--an economy that's not too hot and not too cold. However, chances are increasing that this porridge could start to heat up, a situation that would begin to try the Fed's patience. By James C. Cooper