International Herald Tribune
Thursday 21 February 2008
Washington - The U.S. Federal Reserve Board, for all its power, faces tough new limits on its ability to keep the economy out of a recession.
Even though the Fed cut short-term interest rates twice in January, home mortgage rates have edged up steadily in the past few weeks and credit for businesses is as tight as it was when financial markets seized up last August.
On Wednesday, the central bank, led by Ben Bernanke, found itself facing signs of a problem the United States has not seen in decades: stagflation, the mix of slumping economic growth, sharp spikes in prices for oil and food and a rising pace of overall inflation.
The U.S. Labor Department reported that consumer prices had jumped 4.3 percent in January, compared with the level one year earlier. That was the biggest jump in more than two years. Even after excluding the volatile prices for food and energy, inflation was up 2.5 percent - well above the central bank's unofficial target of 1 percent to 2 percent.
A few hours after the report on consumer prices, Fed officials acknowledged that they had reduced their forecast for U.S. economic growth this year to an anemic pace of 1.3 percent to 2 percent and that joblessness was likely to climb to 5.3 percent from 4.9 percent today.
The Fed's outlook helped propel U.S. stock markets higher on the expectation that the central bank's more dismal outlook for the economy would lead to further interest rate cuts aimed at reviving growth. After being down earlier, the Dow Jones industrial average closed up 90 points, or 0.73 percent, at 12,427.26, while the Nasdaq composite index erased an earlier 0.6 percent loss to close up 0.9 percent.
The Fed's new forecast, however, assumes that growth will be all but stagnant for the first six months of this year before the economy gets a lift in the second half from the economic stimulus package that Congress recently passed and from the Fed's own decisions to lower interest rates sharply.
Although inflation is nowhere near the double-digit rates of the late 1970s, many economists agree with Fed officials that inflation will cool as the economy slows.
But the combination of rising prices and stalling growth, aggravated by the deepening downturn in housing and credit markets, has put the Federal Reserve Board in a box of its own making.
On one hand, officials are cutting interest rates to keep the economy growing at a time when oil prices are surging, credit is tightening and major financial institutions are shell-shocked from the housing and mortgage busts.
On the other hand, the fear of rising inflation makes it more difficult for the Fed to jolt the economy with another wave of cheap money.
Lower interest rates have already pushed down the value of the dollar, which in turn prompted oil-producing countries to push for higher oil prices.
"They are walking a very fine line right now," said Stephen Cechetti, a professor at Brandeis International Business School, in Massachusetts. "They are trying to maintain their low-inflation credibility at the same time they are dramatically cutting interest rates. The facts are that growth is falling quickly, and that inflation is high and rising."
Nowhere have the Fed's limitations been more apparent than in the home mortgage market. Even though the central bank cut short-term interest rates twice in January, in part to stabilize the housing market, investors remained so worried about the longer-term outlook that mortgage rates have edged up steadily in the past three weeks.
"What's disturbing and scary is that the Fed is doing all the right things - cutting rates, and saying they'll do more - but it's not doing anything," said Michael Menatian, president of Sanborn Mortgage, based in Connecticut. "We have hundreds of customers who want to refinance, but they're locked out."
Fed officials do not see themselves as powerless. Its two January cuts in rates, one at an unscheduled emergency meeting Jan. 21 and the other at a scheduled policy meeting Jan. 30, brought the Fed's benchmark overnight lending rate down 3 percent.
According to minutes of both meetings, released Wednesday along with policy makers' latest economic projections, Fed officials were increasingly worried that plunging confidence in financial markets would lead to a self-fulfilling prophecy of tighter credit conditions, stalling activity in the real economy and even more fear in financial markets.
Fed policy makers, according to the minutes, noted that credit was becoming harder to get for both consumers and businesses and that financial institutions were "fragile" after booking huge losses on mortgage-backed securities.
"Some noted the especially worrisome possibility of an adverse feedback loop, that is, a situation in which a tightening of credit conditions could depress investment and consumer spending, which in turn could feed back to tightening credit conditions," the central bank said in its summary of the discussion.
But at least some Fed policy makers were also worried about rising inflation. William Poole, president of the St. Louis Fed, dissented from the first rate cut and Richard Fisher, president of the Fed's Dallas branch, dissented from the second.
The new Fed forecast, a compilation of the individual projections by Fed governors and the presidents of the regional Fed banks, anticipates that inflation will slow down in response to slower economic growth and that consumer prices will rise between 2.1 percent and 2.4 percent this year.
Fed policy makers made it clear they were willing to reduce interest rates to prevent a serious downturn, even if inflation was slightly higher than they wanted, according to the minutes.
"As had been the case in previous cyclical episodes, a relatively low real Federal funds rate now appeared appropriate for a time to counter the factors that were restraining growth, including the slide in housing activity, the tightening of credit availability and the drop in equity prices," the summary recounted.
In a nod to the more aggressive inflation-fighting members on the Fed's policy making committee, the minutes also noted that policy makers should be ready to reverse course rapidly if the prospects for growth improved.
"All this sets the stage for a difficult dilemma for the Fed," Bernard Baumohl, managing director of the Economic Outlook Group, a forecasting company in Princeton, New Jersey, wrote in a report to clients.
"The only sure way the central bank can keep inflation expectations subdued is to tighten monetary policy and raise interest rates until investors, employees and business leaders are convinced that prices will remain low and stable."
But Baumohl predicted that inflation would indeed moderate as Fed officials hoped, noting that major discount retailers like Wal-mart had already cut prices in anticipation of lower consumer spending.
"Pricing power is very limited in this environment," Baumohl said in an interview. "If companies raise prices to keep up with higher costs, they risk losing market share. And once they lose market share, it becomes very expensive and hellishly difficult to get it back."
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