The Fed

More worried about growth

The Fed suggests that growth is now as big a worry as inflation

IN THE past month, a worsening economic outlook, renewed financial turmoil and a big drop in oil prices have all made the Federal Reserve’s anti-inflation rhetoric seem increasingly out of place. The central bank on Tuesday August 5th acknowledged as much, in effect postponing again the date at which it can start to raise interest rates.

“Although downside risks to growth remain, the upside risks to inflation are also of significant concern,” America’s central bank said at the conclusion of Tuesday’s policy meeting. The news was in what it did not say: it dropped the assessment of its statement on June 25th, that downside risks to growth had “diminished somewhat.”

The optimism in June reflected the Fed’s belief that its job of cushioning the economy from the credit crisis was nearing completion and it could turn its focus to inflation and deciding when to start raising its short-term interest rate target from the current 2%.

That view was rapidly overtaken by events. The failure of IndyMac, a mid-sized bank, and a sudden loss of investor confidence in the big quasi-public mortgage agencies, Fannie Mae and Freddie Mac, convulsed markets. A pledge by the Treasury Department and the Fed to back up the two agencies’ borrowing ensured that neither would founder, but they are likely to become even more reluctant to expand their backing of American home mortgages. That is another blow to the moribund housing market, which had shown signs of stabilising.

The Fed’s statement on Tuesday should not have come as a surprise. Ben Bernanke, the chairman, had signalled a renewed concern about the outlook in testimony in July. Only last week the Fed announced that it was expanding and extending some of its liquidity programmes in light of “continued fragile circumstances in financial markets.”

But confusion about the central bank’s priorities has persisted because it has coupled such statements with a continuing drumbeat of concern about inflation. Lou Crandall, chief economist at Wrightson ICAP, a money-market research firm, says the Fed has a “conviction vacuum.” In fact, the Fed has been unclear whether growth or inflation would dominate its decision-making for the rest of the year because the data on both are dreadful.

The confusion has begun to lift. The inflation outlook has improved since June: commodity prices (most importantly oil) have dropped and measures of inflation expectations have improved. The unemployment rate rose to 5.7% in June, up a full percentage point since November and well above most estimates of the natural rate of unemployment, below which inflation tends to accelerate. And with the economy not expected to grow much in coming quarters (it may even shrink), downward pressure is likely on wages and inflation.

The Fed’s statement did not short-change inflation worries this week, of course: “Inflation has been high…some indicators of inflation expectations have been elevated.” But by putting these developments in the past tense, the Fed indicated that the news has stopped getting bad. Moreover, even that degree of concern may not be widely shared. That it found its way into the statement may reflect Mr Bernanke’s efforts to mollify hawkish members of the Federal Open Market Committee who might otherwise have joined repeat dissenter Richard Fisher, president of the Federal Reserve Bank of Dallas, in voting against the decision. Elizabeth Duke, a former banker who was sworn in just before the meeting started, was one of the ten officials voting in favour.