Fed Has Spent Rate-Cut Ammo

Every two months or so, the financial markets fix their attention on the Fed's Open Market Committee meeting, eager for any hint about the bank's next move.

And since June, the Fed, aside from a few clues in its post-meeting statements, hasn't budged.

The Fed's aggressive rate cuts from 2001-2003 to a 45-year low of 1% have helped revive economic growth, but hiring remains tepid. So if the recovery starts to falter, how much ammunition does the Fed really have left in its monetary arsenal?

Some say not much. Sherry Cooper, chief economist for Toronto-based BMO Nesbitt Burns, said the Fed has taken interest rates about as low as it can.

Interest rates "are really accommodative," Cooper said. "I look at the gap between nominal GDP and the fed funds rate and it is at its highest level in 25 years, so you could argue this is the most accommodative monetary policy in 25 years."

"They're going to run the risk of getting into some inflation pressure, even though they won't admit it," she said. "We've seen prices rise a bit and we know commodity prices are rising considerably and as the economy improves, this could bring more pricing power on the part of businesses."

Some economists point to soaring commodity prices and say the Fed should be setting its sights on inflation.

Since November 2001, the Reuters-CRB Index has run up more than 50%. So far those costs haven't been passed to consumers, but the concern is that it can't last much longer.

"They continue to point to deflation and there has been no deflation," said David Littmann, chief economist with Comerica Bank. "They continue to point to inflation of between 1.7% and 2% year-over-year, which is still 70% to 100% higher than the fed funds rate. It's exceptionally irresponsible to have the Fed target interest rates continually below inflation."

Consumer inflation stood at a tame 1.7% in February. Core inflation - which excludes food and energy - registered just 1.2%, just above January's 38-year low.

Producer prices are rising faster than consumer prices. The gap hit a 28-year high in December.

Littmann said the run-up in commodity prices is a sign inflation is on the way. He says rising wholesale prices normally presage higher consumer prices. The Fed, he says, should take that into consideration.

"The problem is, if they're going to conduct monetary policy, they have to take responsibility for knowing something about economic lead times," Littmann said. "They can't wait or even be coincident" with a rise in inflation.

He also notes that despite all those interest-rate cuts, businesses have been reluctant to borrow.

Federal Reserve data show that commercial loans issued by banks peaked at $1.1049 trillion in January 2001. Since then, despite all those rate cuts, they've trudged steadily lower. As of March 10, commercial banks had $894.5 billion in business loans on their books.

"At this point in the business cycle, three years and three months into an expansion, normally you'd see tremendous acceleration in C&I (commercial and industrial) loan demand," Littmann said.

One reason it hasn't happened is the Fed's strict credit requirements make it tough for banks to loan money to some businesses, he says.

"The biggest problems facing many banks today, in their competition with other world financial institutions, are the Fed's regulatory policies on credit," Littmann said. "It's very difficult for many banks to make (business) loans, even at those interest rates."

Mat Johnson, chief economist at Quantit Economic Group, said rising profits in recent quarters have left firms with enough cash on hand that many don't need to borrow.

"The Fed could almost not have lowered rates as they have in the past because most companies are self-financing their investments right now, especially tech companies," Johnson said.

Like Littmann, Johnson notes tighter loan requirements also have damped demand for business loans. He points out that the while the Fed slashed its overnight rate in 2001, the spread between the fed funds rate and commercial loans steadily rose. The spread peaked in the second quarter of 2002 at 2.32% and though it eased to 2.18% at the end of last year, that's still higher than it's been since the early 1990s.

"They definitely have other ways they could provide liquidity to the economy," Johnson said of the Fed. "But I just don't think that's (rate cuts) a key factor behind economic growth particularly when you have companies that look like they're quite capable of financing their own investments."

The Fed also has other options available for honing monetary policy besides interest rates.

"There's another normal means that they used in the early '80s when they targeted bank reserves rather than the fed funds rate," Johnson said. "But because of the money multiplier effect, when you start tweaking bank reserves, it can make monetary policy extremely volatile."

The money multiplier formula works like this. Say you deposit $1,000 in bank A and, according to its reserve requirements, it has to keep 10%, or $100, of your money on hand. It can and does loan the remaining 90% or $900 to bank B. Bank B keeps 10% of that $900 in its vaults and loans out the balance, $810, to bank D which does the same. As the cycle continues, it puts, in accounting terms, more money into the monetary system. And the lower the Fed makes the reserve requirements, the more money that is loaned out.

But changing reserve requirements usually is a last resort. Not only does it make it difficult for banks to make long-term plans, if the reserve requirements are raised, one way to meet them is to call in loans, which can create its own economic headaches.

Rich Yamarone, chief economist with Argus Group, doesn't expect the Fed to make any big moves in the next few months.

"I can't imagine that they would be doing anything simply because there are no significant inflationary pressures on the macro level," Yamarone said. "We get pockets of raw materials and commodities that are really high and then the prices of some foods are falling. So we have somewhat of a balance there.

"Those higher prices at the producer and wholesale level are not getting passed along to the consumer," he continued. "Those companies are letting those costs eat into their profits, which they're gaining back from high productivity."

He doesn't think the Fed is likely to raise interest rates before November's presidential election. Even if signs of inflation do start to surface, a rate hike isn't the only way to head them off.

"What they could do is conduct a little open-mouth policy rather than open market policy," Yamarone said. "They'll talk up the potential or likelihood of raising rates. They could say 'prices are disturbingly high' and that would be the signal they're going to slap on the brakes.

"The bond market would understand that and start selling off the prices of bonds and yields would rise," he added. "And then they can't be accused of raising rates before the election because they didn't. The bond market did it for them."

"I don't think the Fed is going to be as pre-emptive as it usually is," Yamarone said. "The Fed usually conducts monetary policy with a nine-month outlook because it takes that long for policy to take effect in the economy. This time around because the rate of inflation has been so low, I think the Fed can afford to be wrong in its judgment of inflation and refrain from raising rates for awhile."

I think the last paragraph says it all. Because inflation is so low, the Fed doesn't have to be very pre-emptive. Amid all the complaints, I'm fairly pleased with what I see in the economy. Unemployment is at a reasonable rate (5.6%) and declining slowly. The economy is moving forward, slower than we would like but forward always beats backwards. Inflation is practically flat-line.

I just got the smallest raise I ever have (3%) but it is still almost double the inflation rate (1.7%).

Gum

They don't seem to have any problem passing on the high price of commodities at my gas station!

However, the high commodity costs are not a good sign...as costs go up, either prices go up or costs are cut in other areas, like employment. This would help to explain the lack of expansion in employment, which is still a major concern.

However, it's better that prices go up than down. I don't know any economist who thinks deflation is a good thing.

I hate to say it but you've been unduly influenced by the Fed's jawboning. No one in the real world believes inflation is low, unless they do nothing but buy Chinese junk at Walmart and replace their laptop every three months (and they obviously don't put gas in their car to run those errands or ever experience an illness).

I suggest listening to pronouncements of the Fed and Labor Department with a skeptical ear. Those organizations are not in the business of reporting accurate statistics; they are in the business of perception shaping toward political goals. Years later you will find out what they really think when meeting minutes are released, often at variance with the public statements of the time.

Governments do not keep interest rates so low for such an extended period when things are going well.

Governments do not keep interest rates so low for such an extended period when things are going well.

That's exactly what I am worried about, action speaks louder than words. It's hard to feel confident about things when you have an administration that wants to take credit for people employing themselves, classify burger-flipping as manufacturing, appoint an offshorer as manufacturing czar, etc.

However, it's better that prices go up than down. I don't know any economist who thinks deflation is a good thing.

On the flip side, I don't think inflation is any better. The stable monetary policy we have had for the last decade has been great, although it slightly favors inflation (read money borrowers). I know money borrowing is a necessity, but I don't think it needs to be subsidized.

I think you're right. We came out of a quick, sharp recession and things are stable now. Where we go from here, we'll just have to wait and see. If the stock market can be trusted as an accurate forcaster, it seems it is waiting to see how earnings hold up next month. I think they will be good, but who knows how the market will react.

I know money borrowing is a necessity, but I don't think it needs to be subsidized.

I don't understand that statement. Who or what is subsidizing the lenders? Inflation? The Fed?

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