August 5, 2008

Fed Watch: What the Pros Are Saying

The Federal Reserve remains in a tricky position with respect to its Aug. 5 policy meeting. U.S. economic growth remains sluggish, and risks that the economy could tip into recession are significant. That would argue against any upward moves from the current Fed funds rate of 2.0%. But recent data reports show that inflation continues to gather strength, which ordinarily would prompt the central bank to consider tightening policy.

What to expect from Ben Bernanke and his colleagues Tuesday? BusinessWeek and Standard & Poor's MarketScope compiled the thoughts of Wall Street economists and strategists.

Restless Hawks at Bay James Knightley, economist, ING Bank

The June personal income and spending report is going to add weight to the Fed hawks' view that interest rate hikes are needed. The Fed's favored measure of inflation, the core personal consumer expenditure deflator, rose to 2.3% year-over-year from an upwardly revised 2.2% [consensus 2.2%]. This takes it even further above the Fed's so called "comfort range" and is the highest it has been since March 2007. The spending numbers were also better than expected, with consumption up 0.6% [from the preceding month] relative to the consensus forecast of 0.4% [April's numbers were revised down]. Consequently, the Fed is likely to continue signaling that it would ideally like to raise rates. However, given the uncertainty on growth, we doubt that they will be hiking rates anytime soon. The most likely outcome of all this is that the Philadelphia Fed's Charles Plosser joins Dallas Fed President Richard Fisher in voting for a rate hike tomorrow.

No Rise Foreseen Michael Hanson, chief economist, Lehman Brothers

On balance, the risks to both the growth and inflation outlooks have not abated since June's FOMC meeting. While the market is pricing in approximately one rate hike by the end of the year, we view that to be unlikely, barring new evidence that would suggest that inflation and inflation expectations have become unmoored. Should the expected combination of slackening labor markets and moderating commodity prices be realized in coming months, inflationary pressures would rapidly recede. The Fed then could continue to support economic and financial recovery by easing rates again early next year. Such a policy path would be similar to those followed after the prior two recessions. While much uncertainty remains, we continue to see this as the most likely outcome.

High "Risks," Level Rates Joseph A. LaVorgna, chief U.S. economist, Deutsche Bank

The main event this week is [the Aug. 5] one-day FOMC meeting.... The Fed statement should be balanced. [We believe the tone will be neutral. The communique is likely to reinsert the words "significant downside risks" in describing the outlook for growth, but the Fed is likely to remain worried about inflation by repeating that "uncertainty about the inflation outlook remains high" and that "upside risks to inflation remain" even though the committee is unlikely to say that risks have increased since the last meeting. In addition to the rise in unemployment, the decline in oil prices, the collapse in breakeven inflation rates, the firmer dollar, and the modest downward revisions to consumer inflation expectations should tone down the hawkish rhetoric just a notch. Finally, the Fed will probably make some mention of restrictive financial conditions as being something members are worried about.

Last meeting, Dallas Fed President Fisher dissented; he preferred an increase in the fed funds rate. We think Mr. Fisher will vote with the committee this time around, lending credence to our view that the Fed is on hold for some time, at least until policymakers can be sure unemployment has topped and financial conditions are back to some mild semblance of normality.

A Sharper Tone John Ryding, chief economist, RDQ Economics

Core PCE prices rose 0.3% in June, which pushed the year-over-year core inflation rate to 2.3%, from 2.2%. Overall PCE prices rose 0.8% in June and by 4.1% over the last 12 months. The consumer ended the second quarter on a weak note as large increases in food and energy prices more than absorbed the total increase in consumer spending. This fall in real spending in June occurred despite another large tax rebate payment from the government. [By the end of July, all the tax rebate payments will effectively have been made.] We expect little by way of growth in consumer spending in the second half of the year.

The inflation data have to be discomfiting to the Fed, given that its preferred core inflation measure is now at 2.3% year-over-year and, on revised data, has run at 2.2% year-over-year in each of the last three quarters. We expect this to add a little to the hawkishness of the tone of [the Aug. 5] FOMC policy statement, although the 5.7% unemployment rate in July and the 3.4% increase in average hourly earnings should reassure most FOMC participants [though not us] that the Phillips Curve will restrain core inflation in 2009.

A Hike Next Year? David Wyss, chief economist, Standard & Poor's

We expect the Federal Reserve to do nothing [on Aug. 5]. The economic data have been in line with expectations, but with employment down for the seventh consecutive month and the unemployment rate up again, it would be hard to raise rates. The wage data remain stable and moderate, showing no sign, at least yet, of the wage-price spiral that is the Fed's real nightmare. The Fed will probably continue to stress inflation risk a bit more than recession risk. The next move will probably be upward, but not until next year.

Falling oil prices are helping the Fed stay on hold by reducing inflation risk.... Prices continue to swing violently on Middle East politics and demand estimates. If the Middle East calms down, prices should drop, but the odds of that happening appear small. We expect prices to climb back to $150 by year end, but with no confidence in our [or any other] forecast.