Policy-making is gradually becoming tougher at the Federal Reserve, because reading the economy has become harder.

Inflation has surprised Fed officials repeatedly, sometimes slowing more than expected and sometimes accelerating. Economic growth has done the same.

This new degree of uncertainty was evident in the minutes, released on May 24, of the Federal Open Market Committee's May 3 meeting.

There was no hesitation at the meeting about raising the committee's target for the overnight lending rate by a quarter-percentage point, to 3 per cent, because all the committee members agreed the target "remained too low to be consistent with sustainable growth and stable prices in the long run," the minutes indicate.

And that same unanimity about raising the target another quarter-point is likely to persist at the next meeting, on June 29-30.

Nevertheless, with the overnight lending rate now 200 basis points higher than it was a year ago, a few of the committee members say "a larger-than-expected moderation of aggregate demand in response to this cumulative policy action could not be ruled out," the minutes indicate.

Different forecasts

Indeed, there is widespread disagreement among private economists about where the economy is headed in the second half of this year, a disagreement being pondered by Fed officials.

For instance, economist Ian Morris, with HSBC Securities, says he expects economic growth to slow significantly later this year. Even though some data, including payroll gains, strengthened in April, that "doesn't mean we won't get a slowdown in the second half. We are pretty confident we will."

Economists at International Strategy and Investment have a similar forecast. They are telling their clients, "We expect just 2-per-cent real GDP growth here in the United States, and a global slowdown, both lasting through the first quarter of 2006." With such a slowdown, "bond yields seem likely to move below and stay below 4 per cent for some time."

Those forecasts contrast sharply with one released on May 20 by Macroeconomic Advisers in St. Louis.

Inflation key

"We interpret a spate of soft data reported for February and March as a temporary slowing, which will also restrain second-quarter GDP growth to near 3 per cent, and we expect growth to rebound to a modest, above-trend pace of roughly 3.75 per cent through the end of 2006,"Macroeconomic Advisers says.

Interestingly, that growth is accompanied in their forecast by such solid productivity gains that the current 5.2-per-cent unemployment rate doesn't decline over the forecast period.

Also, the forecast sees core consumer price inflation gradually rising to 2.5 per cent, the overnight lending rate going to 4.5 per cent and the 10-year Treasury note yield reaching 5.25 per cent.

In the ISI forecast, Fed officials raise their overnight rate target only one more time, at their next meeting. The HSBC forecast has the target rising to 3.75 per cent before officials become convinced growth and inflation really has slowed and they call a halt.

Inflation is the real key.

In a speech in Germany on May 20, Fed Governor Donald L. Kohn said, "So long as inflation expectations are well anchored, we can tolerate limited changes in inflation. But we need to know that a rise or fall is not the beginning of a more extended trend."

Blip, or trend?

Knowing whether some bad monthly inflation numbers are a blip, or the beginning of a trend, isn't always easy, and it hasn't been easy this year.

"It is no secret that forecasters everywhere did not anticipate the extent of disinflation in the US economy in 2003 and, even after the fact, have had trouble explaining what happened," Kohn says.

"Moreover, the degree to which core inflation picked up in 2004 and 2005 also caught many economists, including this one on the Federal Open Market Committee, by surprise."

One such surprise was mentioned in the May minutes: "The success that some businesses seemed to be encountering in passing through cost increases raised the possibility that competitive pressures and resource slack were exerting somewhat less restraint on inflation than had been anticipated.

"However," the minutes add, "available indicators of wages and benefits had registered only modest growth, suggesting to many that some slack in labour markets persisted. Moreover, market measures of inflation compensation had ebbed in recent weeks, and survey measures of long-term inflation expectations, albeit a touch higher of late, remained in the broad range of recent years."

Containing inflation

In other words, there is plenty of uncertainty about what is happening on the inflation front.

Thomas M. Hoenig, president of the Kansas City Federal Reserve Bank, participated in the March and May committee meetings, even though he isn't a voting member this year. Like Kohn, he has been somewhat surprised at what has happened to inflation this year, and he wants to make sure it stays contained.

Prior to the March session, his bank's board of directors had asked the Fed Board to allow the bank to raise its discount rate by half a percentage point. That was an indication the bank board thought the overnight lending rate target should go up that much as well.

In an interview, Hoenig says a combination of data showing strong economic growth and an acceleration in inflation prompted the Kansas City board's March request, a view he shared.

"The board felt a need to move faster" to get the overnight rate target up to a "neutral level consistent with stable growth and stable prices, which is higher than where we are," Hoenig says.

Mixed data

"That concern did not carry through in the next round," he says. That is, there wasn't the same sense of urgency before the May meeting. "We saw more mixed data" and the board decided, "Let's wait and watch this data a little more," he explained.

Hoenig, who has a reputation of being very focused on keeping inflation low, doesn't think it has gotten out of hand, and doesn't see any need to curb economic growth now.

"I talk about us needing to be watchful," Hoenig says. Part of the acceleration has been due to higher prices for energy and other commodities that have had some effect on core inflation, "and we have more evidence that companies have stronger pricing power than a year ago, not that they can pass everything on."

So, like his committee colleagues, he sees a problem and the need for the overnight lending rate to go higher. His goal, he says, is to get core consumer price inflation, which is now above 2 per cent, "back to the 2-per-cent range."

Hoenig thinks that can happen with economic growth continuing in the 3-per-cent to 3.5-per-cent range, which is what he expects for the remainder of this year.

That is probably a good approximation of what most other Fed officials expect as well. Of course, that's just another forecast.

Bloomberg News

(China Daily 05/30/2005 page11)