Federal Reserve Cites Declines In Housing For Holding Rates

The Fed left rates unchanged at 5.25% and warned that it remains concerned about inflation, making it more likely to raise than lower rates in the future.
By: Greg Ip: The Wall Street Journal Online
What started out as a pause in rate increases last month began to look more like a full halt yesterday.

The Federal Reserve left its short-term interest rate target at 5.25% for a second consecutive meeting. It also warned that it remains concerned about inflation, and thus if it changes rates soon, it is more likely to raise them than lower them.

The statement accompanying yesterday's decision suggested that, since pausing in its two-year string of rate increases last month, the Fed has become more confident that standing pat is justified. In explaining yesterday's decision, it cited the quickening decline in housing activity and easing inflation pressure from energy.

Investors, however, increasingly expect the Fed not just to remain on hold, but to cut rates at least once by next June and again by December 2007. Ten-year Treasury bond yields have fallen, ending yesterday at 4.73%, down from 5.25% in late June. Those expectations may not match the Fed's, at least for now. Indeed, its statement did little to hint a rate cut would be on the table in the near term and financial markets pulled back slightly in their anticipation of one.

Stocks, meanwhile, which have been rallying because of falling oil prices and on hopes the Fed is finished raising rates and the economy escapes recession, extended their winning streak. The Dow Jones Industrial Average rose 72.28 points yesterday to 11613.19, just 110 points short of its January 2000 record.

In its statement, the Fed said growth is moderating, "partly reflecting a cooling of the housing market." By discarding last month's characterization of housing as "gradually cooling," the Fed acknowledged the slide in home construction, sales and, in some regions, prices has picked up speed.

It said that while the "core" measure of inflation, which excludes food and energy, remains "elevated," it was likely to moderate in part because of "reduced impetus from energy prices."

Oil and gasoline prices have fallen sharply in recent months. Oil futures on the New York Mercantile Exchange fell $1.20 yesterday, or nearly 2%, to settle at $60.46 a barrel -- their lowest level in six months and down 22% from the nominal high reached July 14. In theory, such a decline has mixed implications for the Fed. Lower energy prices reduce inflationary pressure, which would call for the Fed to lower rates. They also boost consumer purchasing power, which can improve growth prospects and would call for an increase in rates. The Fed statement suggests it considers the former effect as more important.

While economists differed on what the Fed's next action is likely to be, they agreed that the small changes in its statement signaled greater comfort with leaving rates where they are, despite its stated bias toward raising rates.

"We see these wording changes (and absence of other potential changes) as a step in the direction of a neutral balance of risks," Peter Hooper, chief economist at Deutsche Bank Securities, wrote in a note to clients. He predicted the Fed would drop its bias to higher rates either at its next meeting, on Oct. 24-25, or in December, and would cut rates by March.

The Fed's statement conveys "more of a sense of comfort of being on hold," agreed Bruce Kasman, head of economic research at J.P. Morgan Chase. He noted that inflation remains the Fed's paramount concern. He also expects another rate increase by March.

Ten of the 11 voting members of the Federal Open Market Committee agreed to yesterday's decision not the change the federal-funds rate, which is charged on overnight loans between banks. The Fed had increased that rate at 17 consecutive meetings before pausing last month. As in August, Federal Reserve Bank of Richmond President Jeffrey Lacker dissented, preferring a quarter-point increase. It was the first time in eight years an FOMC member dissented at two consecutive meetings in favor of higher rates, said David Resler of Nomura Securities. The last time, he said, the Fed's next move was to lower rates.

The Fed remains focused on inflation risks in large part because core inflation is above the 1% to 2% "comfort zone" of many Fed officials, including Chairman Ben Bernanke. In the 12 months through August, core inflation was 2.8%, up from 2.7% in the 12 months through July. Using a lesser-known price index that the Fed prefers, core inflation was 2.4% in the 12 months through July.

Fed officials expect core inflation to move back below 2% over the next two to three years as energy prices stop boosting the prices of other goods and services and the economy cools. If that forecast doesn't unfold, it could pose a threat to the Fed's credibility that would require higher interest rates.

The Fed's continuing concern about inflation seems at odds with investor expectations of rate cuts. Thomas Joseph Marta, fixed income strategist at RBC Capital Markets, says that while the Fed and his own firm's economists are optimistic the housing slump won't significantly hurt the rest of the economy, market participants are far more pessimistic. "I've heard traders say, 'Look, the Fed's wrong,'" he said. "Traders are reacting viscerally to housing. Housing is something you see when you're driving home from the train station; it's very obvious, very visible."

Mr. Marta added, "In terms of inflation, I keep whispering in the traders' ears, 'Look, core [prices], hourly wages, unit labor costs, they're all at dangerous levels.' They don't care."

Still, some economists say the bond market will be proven right. Paul Ashworth, senior U.S. economist at Capital Economics of London, said if housing construction's share of economic output falls to the same level it hit in the early 1990s, after the last housing boom, "you'll get a substantial drag on growth." He expects growth to slow to 1.5% next year from a projected 3.3% this year, and the Fed cutting its rate target to 3.5% by mid-2008.

Another reason for the disconnect could be anticipation of easier credit conditions globally. The U.S. bond market is increasingly linked to its foreign counterparts, and there have been signs of slowing growth in Germany, Japan and China in recent weeks.