Fed's new dashboard signals no rate hike soon

Fri, Nov 6 01:59 PM

Enlarge Photo The Federal Reserve Building in Washington while the Fed is inside meeting in this October...

The guideposts the U.S. central bank provided this week on what could drive an eventual move away from its extraordinarily easy monetary policy bolster the case for interest rates to stay low for a long time.

The Federal Reserve said on Wednesday that its near zero percent interest rate policy depends on the state of the economy and it singled out three areas to watch: resource utilization, inflation trends and inflation expectations.

Those guideposts, which the Fed had not included in its previous statement in September, delineate the two sides of the policy equation the central bank must balance: promoting economic recovery while ensuring prices stay stable.

Divisions among the Fed's policy makers on how soon and how aggressively the central bank may have to reverse its emergency support for the economy have become more apparent in recent weeks. The explicit guideposts provided in the Fed's policy statement on Wednesday speak to both camps.

"The change is open to competing interpretations, which may be what eventually led to its adoption," said Andrew Tilton, economist at Goldman Sachs. "For those committee members who see these variables as extremely low, the statement might actually seem like a stronger commitment to keep the funds rate low, but obviously others will see matters quite differently."

The federal funds rate, a benchmark rate set by the Fed, is what banks charge each other for overnight loans.

If recent data is anything to go by, the Fed's guideposts for assessing the need to adjust policy are unlikely to force the central bank's hand anytime soon, analysts said.

The U.S. economy may have shaken off its long recession, but most Fed officials expect the recovery to be slow.

"In the context of the statement, the conditional markers remind the market that the focus is on the level, not the direction, of economic data," said Lou Crandall, an economist at Wall Street research firm Wrightson ICAP.

The explicit outlining of these guideposts is part of an effort by the Fed to be more transparent about its decision-making process. In this way it can reassure markets it has its eye on the ball when it comes to inflation.

The markers also give economists more to hang their hats on. Within minutes of the central bank's statement on Wednesday, analysts began to send notes to their clients on what data points to track to gauge how soon rates may rise.

NO PERFECT YARDSTICK

There seem to be two camps within the central bank, one concerned about a still-weak economy and one worried about the threat of inflation down the road.

One side focuses on the "output gap" between the economy's actual and potential output, putting heavy weight on the unemployment rate and the amount of the nation's untapped industrial capacity.

On the other side is the worry that the sheer amount of money the Fed has pumped into the economy to get credit flowing could spark inflation even with the economy still weak; that side may tend to look more closely at measures that show whether inflation worries are building.

The unemployment rate in September hit a 26-year high of 9.8 percent, and a government report on Friday is expected to show it edged even higher in October.

Along with the worrisome unemployment trend, wage gains have been slowing. A report last week showed wages had grown just 1.5 percent in the year through the second quarter, the smallest gain on records dating to 1982.

A similar tale is told by looking at the degree of industrial capacity being put to use. Although it has been moving higher, reaching 70.5 percent in September, it remains more than 10 percentage points below its long-run average.

Inflation trends similarly are not expected to rock the boat anytime soon.

What is seen as the Fed's preferred inflation gauge, the core personal consumption expenditures price index, stands at an eight-year low of 1.3 percent year-on-year. In fact, it is actually below the 2 percent level that most Fed officials feel comfortable with.

The added guide-posts make the Fed's pledge to keep rates low for an extended period a more "explicitly conditional commitment," said Stephen Stanley, economist at RBS.

"The flipside to that is that the conditions are so weak that in some ways it makes it an even more dovish statement."

LAYING DOWN THE GAUNTLET?

The potential wild-card is expectations of future inflation, which can become a self-fulfilling prophecy when they get out of hand.

Consumers' expectations for inflation over the next five to 10 years -- as measured by the monthly Reuters/University of Michigan survey -- are currently 2.9 percent, below the long-term average of 3.2 percent.

Another measure of investors' inflation expectations over a five-year period -- known as the five-year, five-year forward Inflation Protected Securities (TIPS) spread -- was 2.98 percentage points as of Nov. 2, according to Fed data, somewhat above the long-term average of 2.6 percent.

"That third variable, inflation expectations, potentially becomes the binding constraint," RBS' Stanley said.

"In some way, they've laid down the gauntlet to the market, saying prove us wrong, show us you think inflation is going to pick up," he added.

Some analysts have been flagging the value of the U.S. dollar and commodity prices, such as gold, as a gauge of inflation expectations. Gold, seen as a traditional inflation hedge, has shot up to close to $1,1000 an ounce.

How closely these prices correlate with inflation, however, is unclear and they have not tended to play a prominent role in the Fed's decision-making.

But with the housing bubble still fresh in the minds of officials and with analysts warning that loose policies may be fueling asset bubbles in other parts of the world, asset prices could come to play a bigger role in U.S. policy.

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