Greg Ip

Articles by The Economist’s U.S. Economics Editor

Fed Weighs Pause After Next Rate Cut

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Inflation Worries Loom as Economy Continues to Stall

By GREG IP

The original article is linked here.

WASHINGTON — The Federal Reserve is likely to cut its short-term interest rate by a quarter of a percentage point next week — but then may be ready for a breather.

The Fed, meeting Tuesday and Wednesday, is likely to make what would be its seventh cut in eight months. The reason: Some officials see a case for more insurance against a deeper recession.

But others are concerned a cut could contribute to inflationary pressure with little benefit for growth. That means the option of standing pat will likely also be on the table. If it does cut rates, the Fed could signal in the statement accompanying the decision an inclination to pause and assess the impact of its cuts, which have lowered the federal-funds rate to 2.25% from 5.25% since last year.

Officials say the case for lowering rates further rests primarily on the value of additional insurance against a worse-than-anticipated economic scenario.

The shifting sentiment doesn’t mean the Fed thinks the worst is past for the economy. It is almost certain to signal continued concern about economic growth and a willingness to cut rates further if the outlook worsens.

Still, officials would like to see whether their rate cuts, the Fed’s other steps to lubricate credit markets and imminent tax rebates help produce a second-half recovery.

Moreover, while they think inflation is headed lower over the next year, they are sensitive to the risk that additional rate cuts could stoke inflationary psychology. Once embedded, such psychology can make a temporary rise in inflation permanent. A willingness to pause in rate cuts could help reassure investors the Fed takes the inflation risk seriously.

Fed Chairman Ben Bernanke and his colleagues are unlikely to take rate cuts off the table entirely. The Fed did that in October by saying weak growth and inflation were of equal concern. Within weeks, deteriorating market conditions forced the Fed to signal a resumption of rate cuts.

[Chart]

“They can’t give the all-clear signal, but they can say there’s a presumption in favor of a pause” in rate cuts, said Laurence Meyer, a former Fed governor now at economic forecaster Macroeconomic Advisers.

A gloomy outlook figured in the Fed’s decision to lower its target for the federal-funds rate, which banks charge each other for overnight loans between banks, by 0.75 percentage point in March.

Futures markets anticipate the Fed will cut the rate a quarter percentage point next week and then stop at 2%. The European Central Bank, meanwhile, is holding its key rate at 4% and shows no signs of preparing to cut it.

For the first time in months, the economic outlook confronting officials will be little changed from their prior meeting. Economic data have confirmed officials’ expectation that the economy has likely entered a mild recession. Employment has declined for three straight months, home construction is plunging, and retail sales are weak.

Some things, such as food and oil prices, have gotten worse. Late Wednesday, Starbucks Corp. unveiled a weaker-than-expected estimate of fiscal second-quarter earnings and lowered its forecast for the year, with Chairman and Chief Executive Howard Schultz describing the economic environment as the “weakest in our company’s history, marked by lower home values, and rising costs for energy, food and other products that are directly impacting our customers.”

Oil prices earlier this week reached a new high in futures markets of just under $120 a barrel. Mr. Meyer says the latest $10 increase in the price of oil per barrel would reduce economic growth by as much as half a percentage point. Its rise has hurt consumers as well as energy-sensitive industries such as airlines, which have seen their share prices slump and some small players file for bankruptcy protection.

Still, the economy is showing some positive points. Some borrowing rates, held high by lender risk aversion, have begun to ease, such as on 30-year mortgages that are insured by Fannie Mae or Freddie Mac and for companies with strong credit quality.

Stock prices, while gyrating, have risen 7% since the Fed’s meeting last month as investors conclude all the bad news about loan losses for financial companies has been factored into prices. The Dow Jones Industrial Average rose 42.99 points to 12763.22 Wednesday.

[Federal Reserve Chairman Ben Bernanke (right) listens to Treasury Secretary Henry Paulson testify during a Senate Banking, Housing and Urban Affairs Committee hearing on February 14.] Getty Images

Federal Reserve Chairman Ben Bernanke (right) listens to Treasury Secretary Henry Paulson testify during a Senate Banking, Housing and Urban Affairs Committee hearing on February 14.

Officials acknowledge that some key parts of the financial markets have improved since March. But they worry that banks’ and markets’ tighter lending standards could make for a worse-than-expected downturn.

Fed Vice Chairman Donald Kohn recently described the tightening of lending conditions as “necessary” but said it is “accentuating the downside risks for the economy as a whole…. In some sectors…it is probably going further than is necessary.”

Another concern is that while stock prices and most corporate and household borrowing rates have declined in the past month, the London interbank offered rate, or Libor — a benchmark rate at which banks lend to each other in offshore markets — has moved sharply higher, reflecting increased reluctance by banks to lend cash they might need suddenly.

Fed officials have mulled additional steps to combat this unwelcome condition. They could, for example, expand from its current $100 billion the size of their term auction facility, through which the Fed lends money directly to banks against a wide variety of collateral at a competitive rate for 28 days. They also could lengthen the term of such loans to three or six months.

They would have to weigh the uncertain benefits of such moves against the distortions they would create in the credit markets. Fed officials don’t want the institution to become the main source of funding for the financial system.

Even while downside risks to the economy persist, officials remain unsettled about inflation. While they expect rising unemployment to put a cap on wages and prevent a wage-price spiral, they worry that inflation fears may be feeding a fall in the dollar and the rise in commodity prices, and that further rate cuts could aggravate that inflationary psychology.

More fundamentally, officials want to give the actions they have already taken time to boost growth. Fed governor Kevin Warsh said last week that as credit markets begin to operate more smoothly, more of the Fed’s interest-rate cuts will filter through to the economy. “The problems afflicting our financial markets are indeed long-in-the-making,” he said. “Time is an…essential tool of our policy response.”

—Kevin Kingsbury contributed to this article.

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Written by gregip

April 24, 2008 at 11:27 pm

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