TCS Daily

Fed Cred on the Line

By Desmond Lachman - August 24, 2004 12:00 AM

Recently the Federal Reserve Open Market Committee repeated Alan Greenspan's earlier bold assertion about the sound health of the US economy. By so doing, it clearly signaled to the markets its firm intention to persevere over the remainder of this year with its "measured" pace of interest rate increases. By so doing, the FOMC also very much placed on the line its well-deserved reputation for policy transparency and credibility. For that reason alone, one has to hope that it is right in its assessment that the US economy is only experiencing a fleeting soft patch.

Like Alan Greenspan in his mid-year congressional testimony on July 20, the FOMC recognized that in recent months US output growth has moderated and the pace of improvement of US labor market conditions has slowed. Like Mr. Greenspan as well, it attributed this softness to the substantial rise in energy prices over the same period. Moreover, it boldly asserted that, "the economy nevertheless appears poised to resume a stronger pace of expansion going forward."

A troubling aspect of the FOMC's statement is that it laid the entire blame for the US economy's recent slowdown on higher energy prices. This is not to say that the rise in international oil prices from US$35 a barrel to around US$47 a barrel over the past two months is not having a major impact on consumer spending. For indeed, IMF studies suggest that a sustained US$5 a barrel increase in international oil prices shaves off around 0.3 percentage points from US GDP growth.

However, it is to say that there might very well be other major factors weighing on consumer spending that are not likely to go away in the second half of the year. These factors include the fading away of the springtime tax refunds, which might have boosted household after tax incomes by almost half a percentage point in the first half of the year. They also include the significant rise in long term interest rates since April, which has already resulted in a sharp slowing in mortgage refinancing that had earlier provided such important support to household consumption.

A more troubling aspect of the FOMC's statement is its assertion, without offering any explicit justification, that the economy is now poised to rebound. How sure can the FOMC really be that energy prices will no longer be a drag on consumer spending in the second half of the year, when in fact international oil prices have increased by a further US$5 a barrel since Alan Greenspan gave his July 20 congressional testimony?

Or how sure can the Fed be that the withdrawal of fiscal stimulus and the planned "measured" increases in interest rates will not exert an important toll on consumer confidence? Might it not have been more prudent for the FOMC to level with the markets and to clearly say that in a world of heightened uncertainty, its future interest rate decisions would be fundamentally guided by what the future economic data might show?

By suggesting that the economy is poised to rebound, the FOMC has put itself into a difficult position for its next meeting on September 21. For, if by then, the economy shows further signs of weakening, the FOMC will be loath to abruptly interrupt its program of measured interest rate increases for fear of frightening the markets. Yet further raising interest rates in such circumstances would hardly be helpful to providing needed support to a cooling economy.

What would very much appear to be at stake here is the FOMC's hard-earned credibility. That credibility allowed the FOMC to engineer a 100 basis point increase in long-term US interest rates in April 2004 by simply suggesting that it was moving from a posture of being "patient" towards one of being "measured" with respect to future short-term interest rate increases. It would be a crying shame for the FOMC to lose that credibility, which has been such an important asset in its successful monetary policy management to date. For that reason, one must hope that the FOMC knows something about the US economy that lesser mortals do not.

The author is Resident Fellow, the American Enterprise Institute and a frequent TCS contributor.


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