Fed Unlikely To Cut Rates By John M. Berry Washington Post Staff Writer
Faced with slowing economic growth and a highly uncertain short-term economic outlook, a number of Federal Reserve officials have concluded that the risk of serious weakness in the economy is as great as the risk that inflation will get worse, according to interviews in recent weeks.
The officials, who will meet Tuesday as the Federal Open Market Committee, the central bank's top policymaking group, are expected to adopt that view formally but make no change in their target for overnight interest rates. At the past four FOMC sessions, the members said that inflation posed the greater risk.
Shifting to a neutral stance would leave the FOMC positioned to respond to significant weakness in U.S. economic growth by lowering interest rates, something many investors and financial analysts expect to happen early next year. Some analysts expect growth to slow enough--to around 2 percent or 2.5 percent--that the Fed will reduce rates by up to a full percentage point over the course of 2001. And based on some financial futures contracts, many investors expect the rate cuts to begin at the following FOMC meeting on Jan. 30-31.
But none of the Fed officials suggested there is, as yet, any urgent need to cut rates. Furthermore, in the view of a few, it is still possible for the slowdown in growth to turn out to be just a pause followed by a rebound to the much higher rates of growth of the past two years. In that case, a shift to a neutral stance next week would leave the Fed free to move back to expressing a greater concern about inflation without having whipsawed financial market expectations about central bank policy.
Some of those interviewed would not discuss the policy implications of their views on the state of the economy.
"We've got a slowdown, and a lot of people are quite nervous," said Fed governor Edward M. Kelley Jr. "That's quite predictable. . . . But it's far too early to make a judgment on where the slowdown might stop. If we had a touch-and-go and went back up to high rates of growth, that would be dangerous."
Kelley welcomed slower growth as needed to keep inflation low, saying, "For myself, I hope that the slow, sluggish rise in inflation that we have seen can be topped out by an economy that just slows to trend or just below trend." By trend, he meant the rate of growth the economy can sustain indefinitely, a figure he put at about 3.5 percent.
"We have to cap this incipient rise [in inflation]. I feel we have to cap it here and eventually turn it back somewhat. . . . I would hope that we can slow down to trend and stay there for a while and accomplish that. But that might not be possible," he said.
Several officials stressed the high degree of economic uncertainty involved as the economy moves through a transition to a slower pace for economic growth. Under such circumstances, every piece of incoming economic data gains new importance as everyone searches for hints of what is coming next. Therefore, policymakers should move cautiously, they said.
In particular, the officials are following closely developments in financial markets that have generally made it both more difficult and more costly for business borrowers to obtain credit.
Fed Chairman Alan Greenspan underscored the new risks associated with the growth slowdown in a speech last week in which he noted, "In periods of transition from unsustainable to more modest rates of growth, an economy is obviously at increased risk of untoward events that would be readily absorbed in a period of boom."
Greenspan expressed concern that the higher cost for credit and this year's drop in stock prices could cause what he called "an excessive softness in household and business spending." That was his way of saying that, while the Fed has wanted economic growth to slow, there is a risk that it could slow too much.
Beginning last year, the Fed sought to cool what threatened to become an overheated economy and head off an increase in the nation's underlying inflation rate. To that end, the FOMC raised its target for the federal funds rate--the interest rate financial institutions charge one another on overnight loans--six times, lifting it to 6.5 percent from 4.75 percent. Those increases affected the level of many other rates, including the prime lending rate at banks, which rose by the same 1.75 percentage points, to 9.5 percent.
The prime rate is important because many consumer loans, such as home-equity loans and unpaid credit-card balances, and most small-business loans are tied to it.
The last of the rate increases, a half-percentage-point move, came seven months ago. Given the relatively long lags between the time rates are changed and when the economy begins to respond to the change, both analysts and Fed officials agree that the entire impact of the six rate hikes has yet to be felt.
Whatever the short-term outlook for growth, most of the officials said they see no immediate problem on the inflation front that would prevent a reduction in rates, should that become necessary.
Greenspan's speech suggested that he feels the same way. He mentioned inflation only in terms of whether high prices for energy was spilling over into "general inflation and inflationary expectations." As yet, there is no evidence that it has, though that remains a risk, he said. Similarly, there is a risk that the increased cost of energy could cause consumers to cut back their spending on other goods and services.
But the most significant effect of higher energy prices has underscored the overall lack of inflation in the economy: Profit margins of "corporate businesses, constrained by competitive forces, have not been able to raise prices to fully offset energy cost increases," the Fed chairman said.