For the first time in more than two years, it is impossible to say with certainty what the US Federal Reserve will do when it next meets to set interest rates. Yet the stakes couldn’t be higher. If the Fed continues to raise rates, inflation fighters will cheer, but an already-slowing economy will be squeezed that much harder. If the Fed pauses, consumers and companies will take heart, but at the risk of faster inflation.
Since June 2004, the central bank has been telegraphing its rate moves to guide financial markets through what has turned out to be the longest string of rate increases—17 of them—in a quarter century. But when the Fed meets on August 8th, its members will be torn between battling inflation and supporting economic growth.
The US July employment report, released August 4th, provides new arguments for a pause in the Fed’s rate cycle. The economy created 113,000 jobs last month, about the same as the 112,000 average of the three previous months. That is well down from the average 160,000 jobs the economy has created each month since the employment recovery began in the fourth quarter of 2003. The unemployment rate rose to 4.8% last month from 4.6%.
Labour markets
The Fed for months has justified its rate increases, in part, on tighter labour markets. If that trend is reversing, the case for further rate hikes wanes. Indeed, financial markets took that view. After the report, the price of the US 10-year Treasury bond jumped, pushing the yield down by about 6 basis points, or 0.06 percentage points, to 4.89%. Trading in futures contracts tied to the Fed’s benchmark rate also point to a pause: the implied chance of an increase next week fell to around 21% from 44% before the jobs report.
The Economist Intelligence Unit takes a different view. We believe the Fed is still likely to raise its benchmark rate by a quarter percentage point at its next meeting, to 5.5%. Although the economy is slowing—mainly because of weaker consumer spending—the Fed, in our view, will be more concerned about the risks of accelerating inflation. The government’s second-quarter report on gross domestic product showed the Fed’s preferred inflation measure rose 2.9% at an annual rate, well above the central bank’s 1-2% comfort zone. Wages in the second quarter rose at the fastest rate in three years, and productivity is clearly slowing. Unit labour costs, a key measure for the Fed, are also trending higher. Add to that soaring commodity prices—we expect non-oil commodity prices to rise by almost 24% this year, while oil jumps 27%—and price pressures are clearly bearing down on the economy.
Housing, wages
Are there arguments for a Fed rate pause? Yes, although we find them less persuasive than most analysts. The housing market is clearing slowing, and that will weigh on consumers who have relied on rising prices and home-equity extraction to support spending. But the interest rate on a 30-year loan, after rising steadily for a year, has fallen for the last three weeks and is now around 6.7%—moderate by historical standards. With long-term bond yields no longer rising, mortgage rates are less likely to jump in coming months, lessening the risk of a housing crash. A pullback in housing will also be offset to some extent by rising wages. Labour’s share of income in recent years has been below long-term trends, but that has been changing of late. July’s employment report showed hourly earnings rose by 3.8% year on year, a healthy result and the fourth straight month at around this level.
While the economy does appear to be slowing, the 2.5% GDP growth rate in the second quarter isn’t much below the long-term rate of around 3%. As we have argued before, the US economy needs to grow below its potential for a while—more than a quarter or two—to begin to ease the imbalances that pose a risk not just to the US but to the global economy. Personal saving as a share of disposable income has been less than zero for 15 straight months, and monthly debt-servicing costs are at an all-time high. Consumers have also been buying plenty of imports, which contributed last year to a record $717bn trade deficit. A period of more moderate growth would relieve some of this pressure.
The Fed faces a number of dilemmas that will make the outlook for the economy increasingly uncertain. The central bank is supposed to be looking forward, not back. When it looks ahead, it sees inflation easing in 2007 as the economy slows. Fed Chairman Ben Bernanke made this point when he appeared before Congress last month; if the Fed pauses this will no doubt be one of its arguments. But core inflation, which excludes changes in the prices of food and energy, will likely keep rising in the coming months. This is because the economy is in a transitional phase, with some sectors still performing well. (Companies increasingly are reporting shortages of skilled workers, for example, which may be pushing wages and costs higher.) Base effects from 2005 will make core inflation figures in the coming months also look high.
Self-confidence
It would take an extraordinarily self-confident central bank to end a cycle of rate increases amid rising core inflation. With Mr Bernanke on the job barely six months, the Fed of late has looked anything but confident. The bond markets would also react badly to any suggestion that the Fed was soft on inflation. As we have argued many times, we believe Mr Bernanke will want to err on the side of raising rates too much, not too little.
Our baseline forecast is for the US economy to continue slowing for the rest of this year, with the low point probably coming in the first half of 2007. By that time, the Fed may be ready to cut rates to put a floor under the slowdown and ease growth back up to its potential rate. We are forecasting average GDP growth of 3.3% this year and 2.4% in 2007. But we acknowledge that there are considerable risks to this forecast. The global economy is emerging from a period of extraordinary liquidity. Recall that as recently as two years ago, the central bank interest rate was zero in Japan, 1% in the US and 2% in the euro-zone. This flood of liquidity has had consequences that aren’t well understood—it may explain, for example, why US long-term interest rates have barely risen amid a 425-basis point increase in the Fed’s short-term rate. We continue to worry about a sudden, sharp upward move in long-term rates, and about a steady, and perhaps significant, fall in the dollar.
The Fed—indeed most central bankers—have done a good job of restraining inflation during the last decade. Mr Bernanke is right to worry about the pace of economic growth, but he should be focusing his efforts now on keeping prices in check.
