Fed Faces Big Dilemma Amid Weak Economy

When the Federal Open Market Committee releases its assessment of the economy after a two-day meeting on Wednesday, most economists will be looking for hints about when interest rates may start to move higher. But the Fed may have another, more serious problem: what to do about deflation -- downwardly spiraling prices -- when rates can't go any lower.

At the FOMC's last scheduled meeting in April, there was an upbeat tone about the recovery, saying data suggests "that economic activity has continued to strengthen and that the labor market is beginning to improve."

But things have turned somewhat gloomy in the weeks since then. The Labor Department reported that only 41,000 private sector jobs were created in May, far less than expected. Unemployment remains high at 9.7%. The consumer price index actually declined 0.2% on a seasonally adjusted basis in May. Core inflation increased only 0.9% for the year, the lowest amount in nearly half a century.

"Your starting point is very low inflation and on top of that you've got a very high unemployment rate and a lot of spare capacity in the economy," says Paul Ashworth, U.S. economist at Capital Economics. "There is a lot of lot of downward pressure on wages and prices, which built up during the recession, and it is still there. So you've got an economy pretty much close to deflation already and looking ahead that could be compounded because economic growth is going to remain muted."

Deflation Looms

Anthony Sanders, a professor of real estate finance at George Mason University in Fairfax, Va., says the housing market remains a particular concern. Declining house sales are pointing toward a softening economy, Sanders says, and the large number of foreclosures is putting downward pressure on prices. The government reported a 10% plunge in housing starts in May, while existing home sales fell 2% in the month, both signs of a slackening economy.

"We're seeing other commodity prices having weakness as well," Sanders says. "Over the last year, lumber, cement and other commodities that we use as measures of economic growth are down substantially and I call that deflationary."

The FOMC, which is the government body that sets interest rates in the country, is hamstrung by the fact that the target range for the federal funds rate is already between 0% and 0.25%. It's not possible to set rates any lower to stimulate the economy.

In addition, Ashworth says, there is a concern that the federal government might be forced to tighten fiscal policy -- the use of government spending and tax measures to affect economic growth -- which would only make the problem worse.

Greece, for example, was forced by plummeting bond markets to adopt an austerity program, slashing civil service pay and cutting pensions, because of concerns about its ability to repay it debts. Similarly, if investors became worried that the U.S. can't pay back its huge debts – expected to reach $18 trillion in 2014 -- they might dump Treasury bonds as an investment. This would cause the borrowing costs of the government to surge, forcing Washington to take its own austerity measures. That would hurt the economy.

Even if the government doesn't adopt austerity measures, President Obama's $800 billion stimulus package expires next year and Ashworth expects that will have the effect of tightening fiscal policy by about 2% of GDP.

Growth Is the Main Goal

Ethan S. Harris and Neil Dutta, economists at Bank of America Merrill Lynch, say they think today's FOMC statement will be more dovish on both growth and inflation than the April statement, meaning they will be more concerned about growth and less worried about inflation.

They cited concerns over the labor market, housing, the soundness of banks and pressure for fiscal tightening as the result if the European debt crisis, as reasons why the fed is unlikely to boost rates. The FOMC is "likely to retain its promise to keep rates 'exceptionally low' for an 'extended period,'" Harris and Dutta said in a research note.

The markets seemed to agree with that assessment. The difference between the interest rate on 10-year Treasury Inflation-Protected Securities, which are also known as TIPS, and conventional Treasuries is around 2%. That means investors expect inflation to remain at 2% or less for the next decade.

In fact, Glenn Rudebusch, an economist at the Federal Reserve Bank of San Francisco, wrote in a recent paper that the Fed might not be able to begin its exit strategy from extraordinarily low interest rates until 2012 or 2013.