Inflation news gives Fed room to maneuver

But cutting interest rates too fast could stoke future price pressures
By: John W. Schoen: MSNBC
Tuesday’s report that inflation appears to be under control will give the Federal Reserve’s interest rate-setting committee a little breathing room to make a widely-expected cut in its target federal funds rate for the first time in more than four years.

Forecasters are divided on whether the Fed will cut the benchmark rate by a quarter-percentage point or a more aggressive half-point at its policy meeting Tuesday, as central bankers respond to the first economic crisis since Chairman Ben Bernanke took office 19 months ago.

No matter which course they choose, central bankers still face significant risks. A course of gradual rate cuts could come too slowly to keep the slowing U.S. economy from being dragged into a downturn by the housing recession. On the other hand, rapid, aggressive cuts could spark another round of the kind of easy credit that created the housing bubble — and risk eroding gains in the Fed’s hard-fought battle to keep inflation under control.

The Fed’s rate-setting Open Market Committee got two more pieces of economic data to chew on ahead of Tuesday’s widely-watched rate announcement, which is expected at 2:15 p.m. ET. Wholesale prices fell by 1.4 percent in August, led by a big pullback in energy prices; even without that drop, so-called "core" inflation rose just 0.2 percent, according the Labor Department.

Meanwhile, the ongoing mortgage mess continued to widen in August. As the financial markets remained skittish about the risk of rising defaults, the number of foreclosure filings more than doubled from a year ago and jumped 36 percent from July, according to a RealtyTrac, a Web site that specializes in foreclosures.

As a result, Fed watchers say, the central bank is fighting a battle on two fronts. On one side, it is trying to push money into the banking system, recently cutting the rate on direct loans to banks through its so-called discount window, to calm the storm that hit the financial markets a month ago.

Those moves to pump money into the banking system have already pushed the cost of money well below the Fed’s official target rate. According to the Fed’s own data, the “effective” federal funds rate fell as low as 4.54 percent Aug. 14 as the central bank added liquidity to put out the fires sweeping through money markets.

The Fed tries to maintain its target rate through daily sales or purchases of Treasury securities from primary dealers, adding or draining cash to try to balance the supply of money with demand.

Though the target rate has since moved back above 5 percent, some analysts suggest that the widely expected quarter-point cut Tuesday would merely ratify what is already happening in the financial system. That has led to some speculation that the FOMC could move more aggressively with a half-point cut in the federal funds rate target.

Still, the Fed remains wary of letting up on its other perennial battle front — the fight against inflation. Despite Tuesday's good news on wholesale prices, oil prices are moving higher again — breaking $80 a barrel earlier this month. If the Fed cuts rates too far, it risks creating another credit bubble, or stoking inflation.

Former Fed Gov. Wayne Angell, now a private economist, believes the central bankers can’t have it both ways.

“It's just nonsense to say that the Fed can supply reserves to the discount window and to open market operations and without affecting the target (federal) funds rate,” he said. “There is only one monetary policy. And this monetary policy is apparently confusion.”

Regardless of what the FOMC announces as its target rate, Fed watchers will also be scrutinizing the statement that accompanies the new rate — looking for clues about the outcome of the next regularly scheduled meeting six weeks from now.

“I would like to see the Fed (cut a half point),” said former Fed Gov. Lyle Grimly, now a senior adviser at Stanford Washington Research Group. “But I think the key issue if they go (a quarter-point) is whether the (press) release indicates more help is on the way if needed.”

Despite the recent addition of cash to the U.S. banking system, the global credit markets remain skittish following the implosion of subprime mortgage-backed bonds and the collateral damage to hedge funds, banks and other investors that are holding them. A widening fear about the prospect of further defaults rocked the stock and bond markets last month and raised market-based rates for some other types of lending.

Even as short-term rates have fallen in the U.S., a widely used lending benchmark called the London Interbank Overnight Rate, or Libor, has risen. That’s a sign that banks and investors are afraid of further credit fallout, so they’re demanding higher rates from borrowers to compensate for that risk.

A cut by the U.S. central bank could help calm those lenders and investors and restore flows of cash to some forms of borrowing that have dried up since the credit squeeze began in early August.

“Financial conditions are tighter today than they were a month or two ago,” said Jay Bryson, global economist at Wachovia. “In order to offset that the Fed needs to be easing to try to bring some of those rates down.”

But a move to cut rates is not without risks. The recent turmoil in the credit markets is due in part to a period of easy money policy after the dot-com bubble burst — when the Fed, under the leadership of former Chairman Alan Greenspan, cut the benchmark overnight rate to as low as 1 percent. That policy helped fuel the lending spree that pumped U.S. housing prices to unsustainable levels. Now that the excesses of the housing boom have been reined in, the Fed is loath to begin another round of cheap credit.

The Fed has also long maintained that its primary goal is to fight inflation. On that front, it’s shown good progress: A key inflation indicator the Fed watches closely has recently fallen below the central bank’s perceived target of 2 percent annual price growth.

But loosening credit now could set the stage for higher inflation down the road. Strong demand for crops used for both food and biofuels have driven up food prices. Crude oil recently topped $80 a barrel. A strong global economy has tightened supplies of others commodities like steel and other building materials.

“Longer term, if the Fed is sowing the seeds of an inflation problem and the economy turns out not to be this weak, there could be a price to pay for this long-term,” said Michael Darda, chief economist at MKM Partners.

Assessing the health of the economy is probably the Fed’s toughest task at the moment. Its own survey of economic conditions at the 12 regional member banks last month found that while the pace of economic growth is slowing, business conditions are still relatively healthy. Recent data on industrial production seem to confirm that view.

But last month’s weak employment report — showing a net loss of 4,000 jobs in August — came as a surprise to economists and analysts who had been looking for gains of over 100,000 new jobs. The report also said job growth was weaker than initially reported in June and July.

The rising pace of home foreclosures and the slowdown in mortgage lending also poses a threat to future growth — and raises the possibility that the recession now gripping the housing market spills over to the broader economy. Though such a full-blown recession isn’t inevitable, say many economists, the odds of one occurring have risen as the housing and mortgage markets have fallen.

Former Fed governor Lyle Gramley notes that since World War II, every downturn in housing has been followed by a recession – with the exception of housing slumps in 1950 and 1966 “when we had big increases in defense spending that kept the wolf at bay,” he said.

While some FOMC members may want to cut rates more quickly — by a half percentage point — Fed watchers note that it will be easier to reach a consensus for a quarter point cut. But Bryon is in the camp who thinks that recent signs of economic weakness indicate that a more aggressive cut is needed.

“If over the next few months we find out that (economic) growth is really stronger than we think, and the economy didn’t really need the (half point) cut, they can reverse it and they can reverse it pretty quickly,” he said. “But I think that downside risks to growth are starting to build at this point.”