How Will the Fed Handle a Mildly Positive Economic Outlook?

Mild Good News on Econony WIll Leave Fed on Standyby
Mild Good News on Econony WIll Leave Fed on Standyby

A stream of modestly positive economic reports over the past few weeks means the Federal Reserve probably won't take any further action to stimulate the economy at its key interest rate-setting meeting on Tuesday.

Last week's mildly optimistic data included a drop in initial claims for unemployment compensation to 450,000 in the second week of September from a revised 453,000 the week before, the fewest filings since July. The number of workers collecting jobless benefits under state programs also fell by 84,000.

The government also reported that U.S. producer prices rose 0.4% in August, up slightly from analysts' consensus estimate of 0.3%. Rising prices aren't often a good sign for consumers, but lately, the Fed has been concerned that the country would fall into a deflationary spiral, in which prices fall and people postpone purchases because they expect prices to decline further, leading to lower demand, production cuts and layoffs, all of which feed back into the downward economic momentum. So for once, yes, mildly rising prices are worth celebrating.

The Consumer Price Index also rose 0.3% in August, primarily due to energy prices jumping 2.3% and food rising 0.2%. However, the core inflation rate, which the Fed is most interested in, was up a very modest 0.046%, down from a rise of 0.13% in July -- but at least it was up. Still, a weakness in rents, which make up 42% of the core measurement, is one sign that the economy is not out of the woods yet.

"The numbers show the economy is muddling along at a relatively modest growth rate, and I don't think that is really going to change the calculus for the Fed very much," says Omair Sharif, U.S. economist at the Royal Bank of Scotland.

Wait and See Is the Likely Outcome

Stephen Stanley, economist at Pierpoint Securities in Stamford, Conn., concurs that the situation seems marginally improved.

"The data, in particular the jobless claims figures, do feed into a recent trend of data which has not been great but has certainly been a little bit better than what had been seen earlier, particularly in mid to late August," Stanley says. "So I think the Fed is going to hold off on doing anything at its meeting and will give itself another six weeks to see how the data will continue to play out."

Fed Chairman Ben Bernanke told a meeting of central bankers in Jackson Hole, Wyo., in August that the Fed "is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly."

That said, the Fed is in a bit of a bind because it has already cut interest rates to zero, so it can't officially lower them further. One other tool that it possesses is to buy government bonds. By doing so, it boosts demand, which tends to drive up prices for Treasuries and government-backed mortgage bonds, and push interest rates down further, a process known as quantitative easing.

To Ease or Not to Ease? That Is the Question

The Wall Street Journal, which is used by members of the Federal Open Market Committee to leak their individual views on the economy, reported last week that the committee is still deeply divided about using such monetary easing.

The newspaper quoted Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, as saying that "if the growth numbers come in about where the consensus forecast is, and we continue to get inflation between 1% and 2%, I don't believe I would see a need for further stimulus." Lacker is not a voting member of the committee this year.

Sharif of RBS says he expects the FOMC to trim its forecast for 2011 growth, now estimated at between 3.3% and 3.7%, at its next meeting on Nov. 2 and 3.

"That means the unemployment rate will end up staying higher for even longer than they expected, which I think is pretty much unacceptable for the Fed," Sharif says. "We're looking for them to resume large scale asset purchases in November or December of this year."

Faced with the financial crisis in 2008, the Fed bought $1.7 trillion worth of Treasury bonds and mortgage debt issued by government-backed agencies. It ended its buying spree in March, and began a process of slowly reducing the size of its bond portfolio by not reinvesting in Treasurys as those it held matured.

But at its August meeting, the FOMC announced that it would start rolling over maturing bonds into new Treasury purchases to keep its balance sheet about even.

"The committee seems to be quite divided right now," says Stanley. "I think there are plenty of folks on the committee who feel that we're not even close to justifying further easing, and then there are others who probably would do it right now. But the case is not as compelling as it was two to three weeks ago."