Which is worse: Recession or inflation?
Those two economic ills, the Federal Reserve’s primary concerns, call for opposite policies. Despite recent inflation pressure from higher food and energy prices, Federal Reserve Chairman Ben Bernanke said Thursday, using unusually straightforward language, that the Fed is focused primarily on cutting interest rates further to try to keep the economy from sliding into recession.
“They're in a really tough situation,” said Jason Brady, a mutual fund manager at Thornburg Investment Management. “At the end of day they have a dual mandate" to keep unemployment low and inflation under control.
In Brady's view, unemployment is still relatively low, despite a sharp jump last month to 5 percent, its highest level in two years. But he said he is worried about the inflation rate "getting away from them.”
Rising oil prices, along with costlier commodity prices, have recently pushed inflation above the Fed’s unofficial upper "comfort limit" of 2 percent. Though Bernanke acknowledged the upward pressure on so-called core inflation, which excludes food and energy prices, he said inflation expectations are “reasonably well-anchored.”
That assessment is critical to the Fed’s ability to shore up a sagging economy with lower interest rates. If inflation begins to accelerate, the only reliable antidote in modern Fed history has been higher rates. A commitment to lower rates could also do further damage to the strength of the dollar; higher rates are usually needed to boost demand for dollar-based investments like U.S. Treasury debt. (The dollar fell sharply following Bernanke's remarks.)
The Fed is constantly juggling the opposing risks of setting rates too low to keep inflation in check and setting them too high and choking off growth. Steering that course has never been easy. Policymakers don’t generally tip their hand on future decisions because of the risk that a subsequent change in course could spook financial markets.
But for the moment, the Fed seems to believe that the risks are tipped heavily toward recession. If that outlook is correct, a downturn in the economy could, by itself, ease inflation pressures as demand slows for energy and other raw materials.
“Inflation has perked up,” said Stuart Hoffman, chief economist at PNC Financial Services Group. “I think what the Fed is saying is that they’re taking a calculated gamble that they have some flexibility that inflation won’t keep perking up.”
Though the Fed has apparently determined that a slowdown is the greater of two evils, the central bank’s official forecast still calls for the economy to dodge a recession. Asked about his personal view on the prospects for recession, Bernanke reminded his audience that because of a lag in the collection and analysis of economic data, recessions are often well under way before they can be confirmed by economists.
“You really can't make a determination about that kind of thing until well after the event,” he said, recalling his days at the National Bureau of Economic Research, a private research group whose pronouncements about the timing and duration of recessions are considered the official record of business cycles.
But consumers, investors and voters don’t wait for economists to weigh in before deciding that a recession is near — or under way. Bernanke acknowledged that recent economic indicators, including last month's weak showing in the labor market and uptick in unemployment, “raise the downside risks.” A report Thursday showing that the recent holiday shopping season was the worst for retailers in three years confirmed that consumers began cutting back in December.
Economists have been warning of the threat of a recession for months, largely because of a steep downturn in the housing market after a prolonged boom. Now, some are openly predicting that the economy will slide into a recession this year — if it's not already in one.
On Wednesday investment bank Goldman Sachs, which so far has dodged the multibillion-dollar mortgage-related losses that other Wall Street firms have suffered, said it expects a recession this year, and predicted the Fed will cut the key overnight lending rate to 2.5 percent by the third quarter. The rate currently stands at a two-year low of 4.25 percent after a series of three rate cuts last year.
After months of criticism that the central bank has not been cutting rates aggressively enough and not spelling out its rate-cutting plans clearly enough, Bernanke’s comments Thursday were unusually frank for a Fed chairman.
"We stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks," he said.
But it’s not clear that those cuts will come soon enough to give the economy the boost it needs to skirt recession. Rate cuts usually take months to work their way through the system, though some analysts note that lower rates now could have an immediate impact on homeowners who face rising rates on adjustable mortgages.
Still, the financial markets are more interested in seeing the Fed actually cut rates than just hearing they are coming.
“What we have here is a crisis of confidence,” said David Kelley, a market strategist at J.P. Morgan. “The more important thing for the Federal Reserve to do right now is, don't talk about future rate cuts. Decide on where the federal funds rate needs to be at the end and get it there now. I think it's a sort of drip, drip, drip of interest rate cuts that's undermining business confidence.”