Mixed Signals Pose Problem for Fed Chief
From the May 6, 2007 Sunday Times (London)
May 7, 2007
by Irwin Stelzer
IF you ever get the urge to become a central banker, lie down until the feeling passes. Consider the problem of the Federal Reserve Board chairman Ben Bernanke as he decides later this week whether the economy is headed towards recession, in which case he should cut interest rates; whether inflation is taking hold, in which case he should raise them; or whether steady-as-she-goes might be the wisest course.
Bernanke has made it known that he and his monetary policy committee will be guided by the latest data. So let’s look at those numbers.
Preliminary figures showed that first-quarter growth in the economy slowed to 1.3%. The housing market remains mired in slump. Sales of existing homes in March fell more than 8%, the biggest drop in 18 years, and sales of new homes were 25% below year-earlier levels. Prices are down and inventories of unsold homes are up. The tightening of lending standards after the mess in the subprime mortgage market has made it impossible for some buyers to get financing on manageable terms, and buyers who can get acceptable financing are waiting for prices to fall further.
Many expect the sector’s problems to affect the jobs market and consumer spending in the coming months. Some 100,000 construction workers have already been laid off. With for-sale signs decorating 2m homes, construction won’t pick up soon. And consumers are showing signs of becoming more miserly: the savings rate has risen markedly.
All this has kept inflation at modest levels. The most closely watched figure, the core personal consumption expenditure, which excludes food and energy, was flat in March. Year-over-year, the index rose at a rate of 2.1% in March, down from 2.4% in February. That’s only a tad above Bernanke’s comfort range of 1%-2%.
So score one for those who want the Fed to cut interest rates to stimulate the economy. But a central banker’s life is never simple. Job creation in April was the lowest since November 2004, a sign of cooling. But the unemployment rate, at 4.5%, remains much below the 6% level the Fed believes would ease pressure on wage rates. Equally worrying, productivity growth has fallen from about 4% earlier in the decade to well under 2%, so that higher wages will eventually be reflected in higher unit labour costs, putting pressure on prices.
The Fed will also wonder whether it is any longer sensible to exclude food and energy prices from its considerations. That exclusion was created because of the volatility of those prices. But it is certainly arguable that food and energy prices have reached a new plateau, and should be given more weight in deciding on monetary policy. For example, transport costs are being driven up by petrol prices averaging close to $3 a gallon – the level that shocked the nation in the days after hurricane Katrina. That’s inflationary.
But Wal-Mart’s income-limited customers are trying to beat higher petrol prices by making fewer trips to its stores and buy less when they do go, and consumers are taking cars and light trucks off showroom floors at the slowest annual rate in almost a decade. That should slow the economy and ease inflationary pressures. So higher petrol prices might or might not add to inflationary pressures, all things considered.
Then there is the falling dollar, now at the lowest level it has reached in the 36 years the Fed has been keeping records. The cheap dollar is responsible for the growth in exports. Made-in-America business equipment is now more competitive in Europe and elsewhere. And bargain-crazed European consumers descend on New York in such numbers that an amused Guardian reporter discovered a new pastime in the Big Apple – a game of “spot the Brit” that New Yorkers are playing on the main shopping streets.
Americans are less happy with the shrivelled greenback. Instead of boasting about house prices at dinner parties, they now regale friends with reports of the prices they paid for a pizza or a cup of coffee on their recent trip to London. The lower dollar also makes imports more expensive than they have been in more than 10 years, making it much easier for domestic manufacturers to raise prices without fear of losing business to foreign competitors. That has the Fed’s inflation hawks worried.
Finally, there are indications that the economy is overcoming the downward drag of the housing sector. My guess is that the anaemic preliminary first-quarter GDP-growth figure of 1.3% will be revised upward to nearer a respectable 2%. New orders for computers and other business equipment jumped in March. Thanks to rising overseas demand, the manufacturing sector recorded a surge in production and new orders in April, and the more important service sector grew at a brisk rate.
So if you were a central banker you might reasonably feel that tame inflation allows you to cut interest rates to stimulate the housing sector and offset slower consumer spending. Or you might decide that the economy is strong, rising wages are inflationary, high petrol prices are leaking through to fuel-consuming industries, and that the falling dollar will make it easier for domestic companies to raise prices by reducing competition from imports. So best to raise rates, especially since share prices seem to be bubbling to unsustainable levels.
Or you might be satisfied that low inflation, strength in the manufacturing and service sectors and a low unemployment rate, a weaker dollar to cut into the trade deficit, and a pricked housing bubble are just what you had in mind when you set rates at 5.25%, and do nothing. My guess is that Bernanke will do just that – steady as she goes.
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.