Fed Weighs Growth Risks — Officials Keep Fresh Eye on Slowing Inflation, Europe Even as the U.S. Recovers
By Jon Hilsenrath
15 June 2010
The Wall Street Journal
Federal Reserve officials are beginning to debate quietly what steps they might take if the recovery surprisingly falters or if the inflation rate falls much more.
Fed officials, who meet next week to survey the state of the economy, believe a durable recovery is on track and their next move — though a ways off — will be to tighten credit, not ease it further. Fed Chairman Ben Bernanke has played down the risk of a double-dip recession and signaled guarded confidence in the recovery.
But fiscal woes in Europe, stock-market declines at home and stubbornly high U.S. unemployment have alerted some officials to risks that the economy could lose momentum and that inflation, already running below the Fed’s informal target of 1.5% to 2%, could fall further, raising a risk of price deflation.
The Fed’s official posture is unlikely to change when policymakers meet June 22 and 23: The U.S. central bank is expected to leave short-term interest rates near zero and signal no inclination to change that for a long time.
But behind-the-scenes discussions at the meeting could include precautionary talk about what happens if the economy doesn’t perform as well as expected. “If events in Europe evolve so that they have a more severe and broad impact on financial markets, then the scope of the problems for the U.S. could be magnified,” Charles Evans, president of the Federal Reserve Bank of Chicago, said in a speech last week.
Brian Sack, the head of the New York Fed’s powerful markets group, has talked about “two-sided” risks to the economy — in other words, the risk that growth and inflation could turn out to be lower than expected, as well as higher.
Some so-called hawks at the Fed — those officials who worry most about an increase in inflation — also have acknowledged risks on the economic horizon.
“The European sovereign-debt situation is serious, and there are many unanswered questions about how events will unfold,” James Bullard, St. Louis Fed president, said in Tokyo on Monday.
Mr. Bullard said he expected the recovery to remain on track and to be only slightly dented by the problems in Europe, echoing cautiously reassuring comments by Mr. Bernanke last week. By September, Mr. Bullard noted, the nation’s output of goods and services is likely to have recovered to prerecession levels.
But high unemployment is another widespread concern.
“I would be surprised if the national unemployment rate were to fall below 9% before the end of 2010 or below 8% by the end of 2011,” Narayana Kocherlakota, Minneapolis Fed president, said Friday.
Fed officials have been planning an exit from easy money policies for months. They have allowed several emergency programs to expire. Discussions at recent meetings have focused on such issues as selling some of the mortgage-backed securities the Fed bought during the crisis.
Officials don’t rule out the possibility that markets could settle and the economy could produce a few months of strong job growth and solid consumer spending and business investment. Such developments could prompt them to proceed toward raising interest rates sooner than markets expect, which is early 2011.
But there are other scenarios: if the recovery falters, or if inflation slows much further and a threat arises of deflation, a debilitating fall in prices across the economy. In such cases, there would be a few avenues the Fed could take.
One is asset purchases. During the financial crisis, the Fed purchased $1.25 trillion in mortgage-backed securities on top of buying debt issues by Fannie Mae, Freddie Mac and the U.S. Treasury. Mr. Bernanke has said the steps helped to lower long-term interest rates, including rates on mortgages. The Fed could resume such purchases, although it isn’t clear they would have as powerful an effect as they had in 2008 and 2009, because long-term rates are already low. Rates on 30-year fixed-rate mortgages are about 4.7%, down from 5.2% in early April.
The Fed could also take an intermediate step. Right now, it isn’t reinvesting cash it gets when mortgage-backed securities are paid off by borrowers. If the Fed reinvested that cash — projected to be about $200 billion through 2011 — in mortgage bonds or Treasurys, it would help keep the financial system awash in money and could hold interest rates down.
The Fed also could alter the words it uses to guide markets. Since March 2009, the central bank has said it planned to keep short-term interest rates low for “an extended period.” If the Fed strengthened this reassurance, that could help to keep longer-term interest rates from rising.
There would be big hurdles to taking any of these steps. Inflation hawks at the Fed would surely resist. Meantime, Fed officials would likely worry that embracing a need for additional stimulus could undermine confidence in the economy rather than bolster it.
In any case, a new report by the Federal Reserve Bank of San Francisco, based on projections for inflation and unemployment, suggests the Fed may not need to raise short-term interest rates to curb growth or inflation until early 2012, later than is commonly expected on Wall Street.
The report cites a rule of thumb that the Fed tends to lower the federal-funds rate by 1.3 percentage points if inflation falls by one percentage point and by almost two percentage points if the unemployment rate rises by one percentage point.
Based on that rule, the federal-funds rate — now near zero — would be minus 2.9% under today’s conditions and wouldn’t need to move higher until the first half of 2012, according to San Francisco Fed economist Glenn Rudebusch. The analysis factors in the stimulus the Fed has provided with its mortgage purchases.
“It seems likely that the Fed’s exit from the current accommodative stance of monetary policy will take a significant period of time,” the report said.
