The Fed: What the Pros Are Saying

Third, even though Fed officials seem to have a more upbeat view of the economy than we do, history shows that a rising unemployment rate is a strong impediment to rate hikes even if the funds rate is below its "equilibrium" level. A substantial increase in long-term inflation expectations could change our view because it entails a risk that Fed officials might squander the hard-won credibility gains of the [Paul] Volcker and [Alan] Greenspan years. So far, however, the evidence for such an increase is very limited.

All this suggests that the FOMC will make only small changes to its policy statement at the June 24-25 meeting.

Gabriel Stein, Lombard Street Research

More Fed spokesmen are joining Bernanke in warning of higher interest rates. [James] Bullard, the president of the St. Louis Fed, notes that the Fed must act later in the year to curb inflationary expectations or face a loss of credibility; Fisher of the Dallas Fed says that the upcoming moves to raise interest rates must be deliberate and part of a gradual process. It is indeed beginning to look as if the Fed really will raise interest rates, most likely in August or September, October probably being too near the elections.

However, it is difficult to avoid getting the impression that the Fed has reversed President Theodore Roosevelt's dictum and is speaking loudly while carrying a twig. Not because the U.S. could not do with higher interest rates. In fact, if anything, the surge of hawkish statements are a powerful admission that the Fed's near-panic slashing of interest rates since last September was a mistake. Arguably, it helped the financial system by enabling banks to strengthen their balance sheets, but the injections of liquidity are likely to have been more important, as witness the fact that they (so far) have done the job in the euro zone. But, by comprehensively trashing the dollar, the rapid interest rate cuts also stimulated U.S. inflation.

Steven Wieting, Citigroup (C)

Eight of 10 postwar U.S. recessions have been associated with spiking consumer prices and subsequent disinflation. We have long suspected demand-destroying summer 2008 inflation rates near 5% on surging energy costs, which are globally determined.

Difficult financial conditions and slowing nominal wages suggest demand deterioration and eventual pushback on prices and profit margins. Cost pressures are rising, but sales at higher prices are far from certain.

Aside from cyclical effects, the U.S. has experienced a whiff of stagflation as the broad consumer price index has risen at a 3.6% pace in the past four years, while real gross domestic product grew 2.1%. Oil price gains have proven surprisingly persistent to both monetary policymakers and financial markets, driving that result. There is no monetary solution to product shortages such as oil. Policymakers have rightly warned that steps may be needed to resist pass-through effects if aggregate demand imbalances persist, but only if they persist.

Yet even food and energy demand is eroding at the margin.

Fed tightening is not imminent. But don't be surprised if tightening follows a growth-favorable oil price drop.

David Wyss, Standard & Poor's

Data continue to suggest no Federal Reserve action at [the June 24-25] Open Market Committee meeting. We do not expect any change until the second quarter of next year.

The primary worry at the Federal Reserve is now inflation. Oil prices keep hitting new highs. However, the core producer price index (excluding food and fuel) rose a relatively tame 0.2% in May, the same as the core CPI reading, to give the Fed more reason to stay neutral.

On June 3, Fed Chairman Bernanke said that the Fed is concerned about the rise in some longer-term indicators of inflation expectations. Fed funds futures indicate expectations that the Fed will raise rates 50 basis points by November, to 2.5%. Although it depends on the data, we expect the Fed to remain on hold until mid-2009.