Fed Holds Interest Rates Steady As Slowdown Outweighs Inflation

The Federal Reserve paused in its campaign of rate increases for the first time in 18 meetings, leaving its short-term target at 5.25%, betting that its forecast of slower economic growth will ease high rates of inflation.
By: Greg Ip: The Wall Street Journal Online
The Federal Reserve left interest rates steady Tuesday for the first time in two years, gambling that a nascent economic slowdown will cap growing inflation pressures.

In leaving its short-term interest rate target at 5.25%, the Fed said: "Readings on core inflation have been elevated in recent months," but "inflation pressures seem likely to moderate over time, reflecting contained inflation expectations and the cumulative effects of monetary policy actions and other factors." (Read the statement.)

For the first time since Ben Bernanke took over as chairman on Feb. 1 from Alan Greenspan, the policy-setting Federal Open Market Committee didn't agree to the action unanimously. Federal Reserve Bank of Richmond president Jeffrey Lacker dissented, favoring instead another quarter-point increase.

The statement said, as it did after the last meeting in June, "Some inflation risks remain. The extent and timing of any additional (increases) ... to address these risks will depend on the evolution of the outlook for both inflation and economic growth."

The retention of that sentence in effect reflects a continued bias, but not a presumption, to raise rates in the future. In effect, the Fed gave itself some breathing room to assess the impact of the preceding 17 quarter-point rate increases before deciding whether to hike again. Mr. Bernanke has been suggesting since April that he was seeking more flexibility.

"A pause does not mean a stop," said Stephen Stanley, chief economist at RBS Greenwich Capital Markets. "And there's certainly ample evidence the economy has been on a slowing trajectory over the last couple months. There's enough evidence there for them to take six weeks off."

Signs of slowing growth and rising inflation have aroused deep disagreements among economists on what the Fed should do. Some economists think the Fed has already raised rates too far and is courting recession; some think it must raise them further to stop inflation from accelerating. Some say both things are true.

"You can't fight inflation without risking overkill on the economy," said Ethan Harris, chief U.S. economist at Lehman Brothers, who thinks the Fed shouldn't have paused and predicts it will eventually raise the rate to 5.75%. "That is a risk, and it's a risk they should take." He added: "It's not fair to Bernanke that he steps into his job just as the economy is set to decelerate and inflation takes off."

The Fed's view has been that inflation recently topped the informal "comfort zone" of 1% to 2% , excluding food and energy, primarily because firms have passed higher energy costs on to consumers. If growth does not exceed "potential" -- the rate at which the economy can grow without straining the available work force and capital stock -- and energy prices stabilize, the Fed figures inflation should drop back. Meanwhile, it believes that as the housing market cools and consumer spending slows, business investment and exports will pick up the slack.

But recent data have not been supportive of that view. Economic growth slowed to 2.5% annual rate in the second quarter in part because of a surprise drop in business equipment investment. Macroeconomic Advisers, a forecasting firm, predicts it will grow at about the same moderate rate in the current quarter. Payroll growth was sluggish and the unemployment rate rose in July.

But at the same time, inflation has ticked higher, and new data on productivity, growth and labor costs suggest that inflation pressures have been bubbling longer than previously realized. The Labor Department said nonfarm business productivity grew at a 1.1% annual rate in the second quarter, a sharp decline from the 4.3% growth rate of the first quarter, and was up 2.4% from a year earlier. At the same time, labor costs per unit of output climbed 4.2% in the second quarter, and were up 3.2% from a year earlier. Labor costs were actually declining in 2004, but have steadily accelerated since, and now are rising fast enough to eat into profit margins -- which could encourage firms to try harder to raise prices. Importantly, Tuesday's Fed statement did not repeat a reference from June's that "ongoing productivity gains have held down the rise in unit labor costs."

Revisions to economic data from 2003 to 2005 also show the economy grew less quickly and inflation was a bit higher than previously thought. That, economists say, suggests the economy's "potential" growth rate is lower than previously realized, and the economy may already be straining capacity.

None of this means the Fed is making a mistake now. Indeed, inflation and labor costs were both rising in 2000 when it last stopped raising rates after a cycle of increases. In retrospect, however, the downturn in tech stocks and subsequent decline in tech investment had already set in motion a slide into recession the following year and a big drop in inflation. There are concerns that an accelerating downturn in the housing market today could similarly undermine the overall economy now.

"There was a strong case for pausing at 4.5%," said Ian Shepherdson, chief U.S. economist at High Frequency Economics. "There was already plenty of evidence the previous hikes had begun to soften growth." He predicts the Fed will start to cut rates by next April.

Nouriel Roubini, an economist at New York University and author of a popular economics blog, says it's already too late to prevent a recession. "The Fed should have tightened earlier to avoid a festering of the housing bubble early on. The Fed is facing a nightmare now: the recession will come and easing will not prevent it."

Lakshman Achuthan, managing director at the New York-based Economic Cycle Research Institute, said the economy is not now headed into recession but it is slowing and thus more vulnerable to some kind of shock that tips it into one. At the same time, he said, inflation shows no sign of turning down soon. So, "The Fed may have to stay in the game even though there are elements slowing the economy that still have to play out."