Economics: Fed Speak
New York: May 05, 2004
By John R. Stephenson

So is the fed going to raise rates to stomp out the rise of inflation? Yesterday the Fed left the short-term rate unchanged at a 46 year low but hinted in its language that they were losing "patience" with this low interest rate regime. So, should you start phoning your discount broker and selling your utility shares and bond funds? In our view — probably not just yet.

The reason? The Fed, in spite of its rhetoric, would like to see a little more inflation than we've seen of late. The economic data has been confusing with orders for factory goods rising 4.3% and yet hiring (a sign of economic growth) remains muted. A private survey conducted by Challenger, Gray & Christmas painted a sobering jobs picture — employers had announced job cuts of 6.1% in April. But the big reason we are unlikely to see higher interest rates this year is that we've just gone through an extremely unusual economic period where there has been deep fears of deflation (falling prices).

After the economic bubble burst, we have been swimming in excess capacity. As a society, we have been operating at a level of production below our potential for many years and that has helped to create a situation of over-supply. Add to this, massive imports of cheap manufactured goods from China and elsewhere and you can see that the west is over-supplied. With way too much supply resulting in an inability of manufacturers to raise prices and presto — you have yourself some deflationary worries. But just how to slay the beast of deflation? Well, you need to keep productive capacity at or above the level of potential growth of the economy.

The big problem is, just what is the potential growth of the economy? Certainly there are indicators such as full employment and increasing productivity, which ultimately will result in higher prices (inflation). And there's the rub. We have extremely high productivity and yet anemic job growth (this past month's employment numbers are a rare exception) and generally weak pricing pressure. Sure, a couple of the inflationary data points have been strong, but a couple of data points a trend does not make. The Fed just won't be able to take a chance of a deflationary spiral so it will be sure to wait for a while longer before it starts to crank up interest rates.

In spite of all the talk about losing "patience" with the current monetary stance and the suggestions that this might be election year politics, the big reason why you won't see a change in monetary policy has nothing to do with the Fed getting bored or The White House intervening — things just aren't that great yet.