Comment by Professor Stephen Cecchetti
Published in the Financial Times on May 9, 2006
Rosenberg Professor of Global Finance at the International Business School, Brandeis University
|Bernanke's balancing act
means slow times ahead
Barring a catastrophe, Ben Bernanke, chairman of the Federal Reserve, and his colleagues will on Tuesday announce the 16th consecutive 25 basis point increase in the federal funds rate target, bringing it to 5 per cent.
The big question is: what will they do next?
Inflation is rising, the housing market is weakening and oil prices are up 50 per cent in the past year. The response of policymakers to this challenge will almost surely be to pause as they wait for more information to clarify the very hazy economic picture.
Starting with inflation, the March US consumer price index contained an ominous signal. Housing costs rose 0.44 per cent for the month (annualised, that is 5.4 per cent). Normally, one should not put too much stock in one month's data, but in this case we should.
US inflation is unusual in that it treats renters and owners symmetrically using surveys to infer the rents homeowners would pay if they were to rent the houses from themselves. Because two-thirds of Americans own their own home, this rent-based measure represents nearly one-quarter of the headline inflation index. So, understanding inflation means understanding rents. Here the news is very bad.
Over the past five years, prices of homes have risen by more than twice as much as rents. Last month's numbers suggest that this gap will be closed mainly through rent increases, rather than house price declines. At the current pace, with rents rising 5Â½ per cent per year, this will take three years, adding more than a full point to headline inflation each year. The housing boom, through the impact of increased wealth on consumption, has been raising real gross domestic product growth by about 1Â½ percentage points a year for the past five years. With flat housing prices, this engine of growth has disappeared.
Finally, we come to oil prices. When energy prices rise everyone worries about inflation but the biggest impact is on growth. We now have to pay foreigners more for the energy we are already using; and we are stuck with overly energy-intensive automobiles and capital equipment. The result is that spending on non-energy items has to grow much less quickly, if at all. The result is lower growth.
I have painted a bleak picture: rising inflation and falling growth. Stabilising one destabilises the other. How will Mr Bernanke and the rest of his Federal Open Market Committee react? In recent months, they have emphasised both the importance of anchoring long-term inflation expectations and how low inflation enhances the Fed's other statutory objectives of high employment and moderate long-term interest rates. The message is that policymakers are committed to keeping inflation low. That is their primary objective.
As for the current circumstance, two forces will combine to slow everything down. The first is uncertainty. Second, there is the need to balance the competing goals of low inflation and stable growth. As I have argued, there are strong reasons to expect inflation to rise and growth to fall. On their own, these would require diametrically opposed interest rate policies. Put them together and the appropriate response is to bring inflation down slowly so as to keep growth as stable as possible.
At times like these a system where inflation is the sole (or even primary) objective of monetary policy can create difficulties. The problem is communicating why it is that inflation is going to be allowed to rise so that real growth does not deteriorate too badly. It is a difficult balancing act but there is little anyone can do about that.
By the end of 2006, rates will be still above 5 per cent. To figure out how much higher, we can use the following rule of thumb: for every percentage point inflation rise above 2 per cent, the federal funds rate target needs to rise by 1Â½ percentage points above the neutral level of 4Â½ per cent. So, if inflation were to go to 3 per cent, the federal funds rate would have to rise to 6 per cent. That is the maximum. If growth slows, then there will be no need to get quite that high.
When interest rates were 1 per cent in mid-2004, I calculated they needed to get to 4Â½ per cent. In mid-2005, when it became clear how long it would take to get there, I began thinking 5 per cent would be the peak. With interest rates so low for so long, housing price increases are now leading to higher rents, which feed directly into headline inflation. Controlling this means continuing to raise interest rates. Regardless, balancing the competing forces means going slowly.
Stephen G. Cecchetti is Rosenberg Professor of Global Finance at the International Business School, Brandeis University.
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