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Extremely low inflation { December 5 2003 } Original Source Link: (May no longer be active)
http://www.washingtonpost.com/wp-dyn/articles/A36955-2003Dec4.htmlhttp://www.washingtonpost.com/wp-dyn/articles/A36955-2003Dec4.html
Fed Watchers Seek Signal on Interest Rates
By John M. Berry
Washington Post Staff Writer
Friday, December 5, 2003; Page E01
Federal Reserve officials from Chairman Alan Greenspan on down have made it clear in a series of speeches that they have no intention of raising interest rates when they meet in a policymaking session Tuesday. But financial analysts and investors are intensely interested in whether the officials will signal that recent very strong economic reports may lead them to raise rates sometime early next year.
Based on the officials' statements and the nation's combination of relatively high unemployment and extremely low inflation, an increase in the central bank's key 1 percent target for overnight interest rates appears unlikely for many months.
The analysts and investors are focused on whether the officials will change any of the wording in the statement they issue after the meeting, wording that since August has emphasized that the central bank has been more concerned about a further drop in inflation than about any acceleration. Following the last policymaking meeting in October, the statement said the officials believed that rates could remain low "for a considerable period."
Many analysts expect that phrase, which has been controversial among Fed officials, to disappear from next week's statement. That could happen, but appears unlikely. More important, even if the language were changed, it would not signal an imminent rate increase. After all, in a speech last month, Greenspan that even with economic activity improving, inflation is so low that "monetary policy is able to be more patient" than in past periods of strong growth.
One reason Fed officials are so relaxed about inflation is that it is low, but another reason is that the largest single cost of most firms, the cost of labor embedded in each good or service produced, is falling, not rising. For example, in the year ended in September, productivity growth was so strong that unit labor costs fell 2.2 percent.
Using very straightforward language in a speech two weeks ago, Fed Vice Chairman Roger W. Ferguson Jr. laid out a view shared by many of his colleagues. First, economic growth might falter again. Second, large gains in productivity -- the amount of goods and services produced for each hour worked -- mean the economy can grow faster than used to be the case without putting upward pressure on prices. Third, there is a large "output gap," with actual production running well below what could be produced without causing more inflation. And fourth, research has shown that after an extended period of low inflation, prices are less likely to rise as the unemployment rate falls than they were in the past.
"While the consensus forecast for next year calls for a growth rate of 4 percent, which seems reasonable, a weaker outcome than that is not hard to imagine," Ferguson told a Chicago audience. With potential growth higher than in the past, it will take strong growth to reduce the output gap, which "is likely to persist for some time even if real GDP [gross domestic product] grows in excess of its potential pace."
Finally, with prices less sensitive to the level of joblessness, "unlike in past periods, the specter of rising inflation is less likely to haunt the economy as activity improves and the output gap shrinks," Ferguson said. "Indeed, inflation still seems more likely to move lower than to increase. Under these circumstances, the central bank has the luxury to monitor events before it has to confront the need to return the stance of policy to a neutral position."
In Fed parlance, a "neutral position" is one in which the level of interest rates is neither stimulating nor restraining economic growth.
Thomas M. Hoenig, president of the Kansas City Federal Reserve Bank, said in an interview late last month that a forecast of about 4 percent growth next year "is in the ballpark. . . . On balance, I am fairly optimistic about the U.S. economy and the world economy as we move into 2004."
Such a growth rate, with productivity gains of around 2.5 percent to 3 percent, should be enough to begin to close the output gap and reduce unemployment, Hoenig said. And he was sanguine about prices. "I don't see inflation as an issue in the 2004 time frame, unless growth shot up consistently at a 7 percent rate," he said.
As for the "considerable period" language in the Fed policymakers' statements, Hoenig said, "My own sense is that the economy will speak for itself. It will be so readily apparent that, at the right point, [eliminating the phrase] will become a non-event."
Hoenig's counterpart at the San Francisco Federal Reserve Bank, Robert T. Parry, said in a speech late last month that this recovery is different from past recoveries and that Fed policy has to be different too.
"Conditions today aren't typical," Parry told an Australian group via a teleconference. "In fact, this is the first expansion in over 40 years that began with a very low inflation rate. So the response of monetary policy isn't necessarily going to be typical, either."
Typically, when an expansion takes hold, the "main concern is an upside surprise -- that is, the possibility that the economy will come roaring back, possibly pushing the inflation rate even higher, or at least preventing a desired decline," Parry said. Guarding against that risk has required that the Fed raise interest rates fairly quickly, but not this time.
The Fed's current policy reflects "the high level of excess capacity and the low level of inflation. Given that, I believe there's still room for some pretty strong growth before the risk of inflationary pressures would become a primary concern," Parry concluded.
None of the statements by Greenspan, Ferguson, Hoenig or Parry -- or those of their colleagues who have spoken in public recently -- appears to suggest any desire to raise interest rates soon, or even to make substantive changes in the language of their October statement.
© 2003 The Washington Post Company
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