Last week’s report of rising employment, coupled with data showing sizzling growth in the third quarter, has stirred expectations that the Federal Reserve could raise interest rates next spring for the first time in four years. But with presidential elections looming and inflation virtually non-existent, many analysts believe the central bank will choose instead to sit on the sidelines until late next year or even 2005.
With benchmark short-term rates at their lowest level in 45 years, the Fed’s decision is critical because any rate hike inevitably will be seen as the first in a series of moves to tighten credit and rein in growth. When the Fed finally made its first upward move in 1994 after the last recession, it boosted rates seven times in a year.
Futures traders, who have $1.5 trillion riding on the Fed’s course of action, have factored in a 72 percent chance policy-makers will boost the short-rate at their scheduled mid-March meeting. Just a few months ago many traders were betting that the Fed might lower the overnight federal funds rate below its current 1 level of percent or take other action to prevent the emergence of deflation.
The New York Times, jumping into the debate in a Nov. 9 editorial, urged Fed Chairman Alan Greenspan to shorten his horizon for raising rates. “It’s clear that these record-low interest rates, which sustained consumer spending during the slowdown as people rushed to refinance their mortgages and otherwise take advantage of easy money, are no longer prudent,” the Times opined.
That kind of reasoning strikes some Wall Street analysts as ludicrous.
“Just a few months ago we were worried about a vicious downward spiral in pricing,” said Citigroup senior economist Steven Wieting. “And now times are getting too good, and the Fed is going to spoil it? … The idea that this needs to be choked off is really troubling.”
One reason many traders and some forecasters believe the Fed may have to hike rates soon is history: In the past the Fed typically has moved rapidly to tighten credit after initial signs that the economy is on its way to a strong, sustainable recovery. But this time is different, argue many analysts, and not just because of the increased sensitivity required to act in the midst of a presidential campaign.
Extremely low — even dangerously low — inflation and the severe job losses that have accompanied the current expansion will allow the Fed to remain extremely patient and fulfill its oft-stated promise to leave policy accommodative for a “considerable period,” these analysts argue.
“The Fed is not going to be spooked by strong growth,” said former Fed Gov. Lyle Gramley, now a consultant to Schwab Washington Research Group. “They are going to wait until inflation moves up to raise interest rates.”
He and other analysts point to two crucial and closely related factors: inflation and unemployment. In past recoveries, the Fed typically has not begun raising rates until the economy has created a significant number of new jobs, surpassing its previous peak. After the so-called jobless recovery of 1991-92, for example, the Fed waited until the economy had added more than 4 million jobs from its trough level before beginning to raise rates.
Under the most optimistic of projections — that is, the one issued by Treasury Secretary John Snow — the economy is expected to create only 2 million jobs over the next year, not even enough to make up for the 2.6 million jobs that disappeared in the long downturn. So far the total is less than 300,000 jobs created over the past three months of modest growth.
The inflation picture is even more unprecedented. Throughout the 1970s, ’80s and ’90s, the Fed has been quick to pull the trigger on rates because of concerns about the potentially destructive impact of inflation. But over the past year the core inflation rate has fallen so low that the central bank has begun to discuss the dangers of deflation, unseen in the United States since the 1930s.
While an outbreak of deflation is considered an extremely remote possibility, the core inflation rate remains well below the Fed’s presumed target of about 2 percent and could fall further, said James Glassman, a senior economist with J.P. Morgan Chase. “The consequences of (deflation) are so severe that the Fed is more concerned about getting away from that,” he said. “They want to pull back from the brink.”
In a speech last week, Fed Gov. Ben Bernanke pointed out that in the jobless recovery of 1991-92, inflation continued to fall even after employment began to grow. “Because the post-trough recovery in the labor market has been so much slower this time around, the experience of the earlier episode suggests that the current risk of increased inflation is, for the time being at least, quite small.”
He concluded by reiterating that policy can remain “accommodative” without causing inflation.
Opinions on when the Fed will make its initial rate hike are sharply divided. In a Reuters survey of forecasters at 18 major brokerages, conducted after last week’s employment report, six predicted the Fed would begin raising rates in the first half of 2004, seven said the second half of 2004, and five thought the Fed would wait until 2005.
“The Fed cannot remain where it is indefinitely,” said Lynn Reaser of Banc of America Capital Management, who expects an initial rate hike by next summer. “Monetary policy remains very stimulative, with real interest rates at zero or negative.”
One wild card on the table is next year’s election campaigns, which will begin heating up early in the year with the first Democratic primaries and caucuses. The Greenspan Fed has not shied away from raising or lowering interest rates in an election year, including an unusual August rate hike in 1988. That move did not prevent Republicans from retaining control of the White House, but central bank policy-makers would prefer to stay as invisible as possible in the months leading up to Election Day, analysts say.
“If it came to a point where it was a real close call, (the election) would play a role,” Glassman said. “They wouldn’t want to do something that would be seen as swaying an election one way or another.”