The monetary policy vise is tightening on the Federal Reserve.
On one side, there’s a slowing economy that would normally tempt policy makers, who have already lowered interest rates to near zero, to try to add more monetary stimulus through other tactics such as buying longer-term bonds to cut their rates and push cash into the economy. On the other, there’s rising inflation that suggests there’s already more than enough stimulus.
And sitting in the middle of it all, there’s Fed chairman Ben Bernanke, who heads an interest-rate setting committee that’s increasingly split between those who believe the economy needs more help and those who are concerned that the Fed is overreacting and courting a damaging surge in prices.
“Certainly in the U.S., there’s a bit of a conflict going on where the news on the economy is fairly weak but at the same time the news on core inflation is pretty strong, which leaves the Fed in a particularly tricky position,” said Paul Dales, senior U.S. economist at Capital Economics.
If there’s any consolation for Mr. Bernanke, it’s that he’s not alone in his dilemma. There’s a similar conundrum for the European Central Bank, which raised rates earlier this year. Recent figures show that the biggest and strongest European economy, Germany, is cooling quickly while inflation in the euro zone is still above the central bank’s target.
A spate of reports Thursday drove home the severity of Mr. Bernanke’s situation.
Manufacturing in the Philadelphia region contracted by the most in two years in August; sales of existing homes in the U.S. fell 3.5 per cent in July from the previous month; and first-time claims for jobless benefits increased by 9,000 last week, pushing total claims back above 400,000.
These data are secondary indicators. Still, the numbers are awful. All things being equal, they would prompt a response from the central bank. But that’s not likely to happen, because of a fourth report showing the consumer price index jumped 0.5 per cent in July on higher gasoline costs. More troubling is additional evidence of upward pressure on core prices, which exclude food and energy. The core rate rose 0.2 per cent on the month and was 1.8 per cent higher than a year ago.
Policy makers aim to keep inflation at an annual rate of about 2 per cent. The CPI isn’t the Fed’s preferred measure of inflation, yet it remains a strong guide. The core rate is signalling that higher energy and commodity costs are forcing businesses to charge higher prices, pushing underlying inflation close to the Fed’s target.
The result is policy paralysis. New York-based investment bank Morgan Stanley said Thursday that the U.S. is “dangerously close” to a recession. However, until inflation subsides, the Fed is limited in what it can do to stimulate demand. Mr. Dales of Capital Economics, a consultancy based in London, said the latest CPI data could keep the central bank from embarking on a third asset-purchase program until next year.
As always, there are flecks of data that contradict the overall tone. The latest report on U.S. leading indicators rose 0.5 per cent, a solid increase that suggests the economy is pulling out of the swamp it ran into in the first half. Or does it?
The rise in the leading indicator resulted from a rise in money supply, but that may just have been investors pulling money out of risky assets and parking it in cash. In that case, “we think the sign on this particular variable should be negative rather than positive,” Goldman Sachs economists said Thursday. “We take no comfort from the increase in the July index.”
Similarly, there’s reason to play down the fact that the four-week moving average of initial jobless claims fell to 402,500 last week, the seventh consecutive weekly decline.
Bank of America Merrill Lynch’s Joshua Dennerlein pointed out in a note Thursday that almost half of the U.S.’s unemployed are collecting jobless benefits. At the end of the year, extended benefits are set to expire, putting at risk the unemployment insurance payments of more than 3.5 million people. “After the expiration, only a quarter of the nation’s unemployed will be collecting UI checks,” Mr. Dennerlein said. “This will act as a hit to income, hurting consumption in the first half of the year.”
There’s little reason for consumers and businesses to feel good about spending money. The median expectation of Wall Street economists was that sales of existing homes would increase in July. Another decline suggests the U.S. housing market still is looking for a bottom.
The big focus now will be on Mr. Bernanke’s speech next week in Jackson Hole, Wyo. This time last year, he used it to signal plans for a new round of monetary stimulus. But at that point, inflation was barely registering.
Now, with inflation gaining pace, the odds are diminishing that Mr. Bernanke will be able to convince his colleagues on the rate-setting committee to another round this year.
Three members of the Fed’s 10-member rate-setting committee voted against the majority’s decision last week to state explicitly that borrowing costs would remain low to 2013, the biggest split for decades. One dissenter, Philadelphia Fed president Charles Plosser, told Bloomberg Radio Wednesday that policy should be determined by economic conditions, not “the calendar,” and he thinks most of his colleagues are too negative on the U.S. economy’s prospects.
“I suspect if Ben Bernanke was the only one on the committee and he had everything his way, he would pretty much be ramping up to more policy easing,” Mr. Dales said. “It is a committee, and to some extent there does need to be some kind of consensus.”