Fed's Economic Forecast Is More Right Than Wrong: John M. Berry
By John M. Berry
April 10 (Bloomberg) -- Investors and analysts who are placing bets that the Federal Reserve will cut interest rates later this year are convinced the Fed's economic forecast is off base. So far, that forecast is looking a lot more right than wrong.
In congressional testimony on March 28, Fed Chairman Ben S. Bernanke summed up the central bank's view:
``Overall, the economy appears likely to continue to expand at a moderate pace over coming quarters,'' Bernanke said. ``As the inventory of unsold new homes is worked off, the drag from residential investment should wane. Consumer spending appears solid, and business investment seems likely to post moderate gains.''
Ten days later came the March employment report with its 180,000 gain in payroll jobs and a dip in the unemployment rate to 4.4 percent. While a weather-related swing in construction work made the report appear stronger than it really was, it certainly didn't point to the sort of weakness that could lead the Fed to reduce its 5.25 percent target for the overnight lending rate.
Some of the bettors -- such as Goldman Sachs Group Inc. -- did react to the labor news by pushing off the first expected rate cut from June to September. Otherwise, they were generally sticking to their guns.
Some indicators -- such as ``housing starts and the ISM manufacturing index in particular -- have weakened very much in line with our expectations,'' Goldman Sachs economists said in an April 6 statement. ``But employment and inflation, arguably the two most important, have pushed in the other direction.
Housing Problem
``As a result, we now expect Fed rate cuts to begin in September, rather than June. We still expect 75 basis points of easing by the end of the year,'' the statement said.
The Goldman Sachs economists' conviction about slowing growth and Fed rate cuts is rooted in what they call ``the rapid contraction in the housing sector,'' which Bernanke agreed in his testimony has been and will continue to be a drag on growth.
The issue though is whether that weakness will spread to other parts of the economy, particularly to consumer spending. And outside of sales directly related to housing, such as furniture and building supplies, Fed officials don't see such a spread as yet.
Nor do some other forecasters, such as those at Macroeconomic Advisers in St. Louis, who agree growth will be below trend in the near term and then pick up again in the second half of the year -- exactly what Fed officials have been predicting.
Growth to Rebound
``We are tracking GDP growth at 1.7 percent in the first quarter and project growth of 2.2 percent in the second,'' Macroeconomic Advisers said in an April 6 commentary. Gross domestic product rose at a 2.5 percent annual rate in the final three months of 2006.
``Despite the sluggish near-term pace, we continue to expect that, as identifiable sources of drag diminish, growth will rebound to near trend in the second half of this year,'' it said. The key source of drag, of course, is housing.
The March labor report didn't just make an interest rate cut less likely by giving some reassurance on growth, though. It did the same thing by highlighting a potential problem in core inflation.
``The employment report will heighten the Federal Reserve's ongoing concerns over upside inflation risk arising from the high level of resource utilization and keep the Federal Open Market Committee focused on inflation as its predominant concern,'' the commentary said.
``Accordingly, we continue to expect the committee to hold the federal funds rate unchanged at 5.25 percent through 2007.''
Core Inflation
Another element in the Fed forecast is that core inflation will fall gradually this year and next. Bernanke reiterated that in his testimony while saying that ``the risks to this forecast are on the upside.'' And he singled out ``the tightness of the labor market'' as one of those inflation risks.
The investors and analysts betting on a rate cut seem to be underestimating the Fed's concern about core inflation, which is clearly higher than officials want it to be. A key reason for that concern is the need to restrain long-term inflation expectations, Bernanke and a number of his colleagues have said.
In a March 23 speech, Fed Governor Frederick S. Mishkin said there is evidence that inflation has become ``less persistent'' than in the past ``because better monetary policy has anchored inflation expectations more solidly.'' A ``less persistent'' inflation is one that can be brought down with less of a squeeze on the economy, he said.
Dual Mandate
``At the Federal Reserve, we understand the importance to the health of the economy of anchoring inflation expectations. This is why Federal Reserve officials continually reiterate our commitment to maximum sustainable employment and price stability,'' Mishkin said.
This dual mandate isn't only a legal responsibility for the central bank. The two goals are intertwined.
In the current economic context, policy has been directed toward sacrificing some economic growth in the short run to reduce core inflation and keep inflation expectations in check.
On the other hand, core inflation isn't so high that there is any intent to trigger a recession to bring it down. Still, it is sufficiently elevated that a decision to cut rates involves a pretty high hurdle.
Bettors should keep that in mind.
(John M. Berry is a Bloomberg News columnist. The opinions expressed are his own.)
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