Secret of the Up-or-Holding Rate: Tuesday's Fed Mystery Theater

By Nell Henderson
Washington Post Staff Writer
Friday, August 4, 2006

Federal Reserve policymakers haven't provided a wink, a nod or even a coded phrase to telegraph what they plan to do with interest rates when they gather Tuesday -- the first time in three years the outcome has been uncertain so close to their meeting.

The reason, analysts say, is simple: Fed members themselves don't know, with some pressing for the 18th consecutive increase in interest rates and others ready for a break.

But the situation reflects something more: a shift in the Fed's communications strategy. Instead of providing short-term guidance about interest rates, the new chairman, Ben S. Bernanke, is highlighting a long-range view of where he wants the economy to go over 18 months or longer.

That contrasts with the practices of his predecessor, Alan Greenspan. In his last 2 1/2 years as chairman, Greenspan sent clear signals ahead of time to prepare financial markets for Fed decisions on interest rates. Bernanke continued that policy when he took over in February.

If Bernanke sticks with the new approach, stock and bond investors will have to do a lot more guesswork about where interest rates are headed.

Bernanke used his most recent public appearance July 19 on Capitol Hill to highlight the Fed's economic forecast over the coming 18 months. In doing so, he outlined the collective goal of the policymaking Federal Open Market Committee: a so-called "soft landing" in which the economy slows down just enough to tame inflation without sliding into recession.

And he said the forecast represents what the policymakers expect to happen if they adjust interest rates just right -- without saying specifically how they will do so.

This approach is called "inflation forecast targeting" by Fed economists and academics. By contrast, Greenspan didn't play a role in drawing up the Federal Open Market Committee's economic forecasts, and often ignored them in talking to Congress. He was generally skeptical of economic models and frequently questioned the Fed staff's forecasts.

Financial markets rallied strongly when Bernanke appeared before Congress, in large part because his testimony implied that the Fed doesn't plan to raise rates more aggressively this year to bring down inflation faster. By yesterday, traders in futures markets were pricing in about a 60 percent chance that the Fed will leave its benchmark rate unchanged Tuesday at 5.25 percent, and about a 40 percent chance it would raise the rate to at least 5.5 percent.

The communications shift reflects the Fed's growing uncertainty about when to stop raising interest rates.

With the economy losing steam and inflation accelerating, the Fed does not want to raise rates too much and tip the economy into recession, or raise rates too timidly and let inflation get out of control.

"If you don't know which way you're going, it's hard to send up a flare," said former Fed vice chairman Alan S. Blinder. "This is pretty close to a 50-50 call."

Three years ago, the Fed's path was much clearer. In June 2003, the central bank had just cut its benchmark rate to a four-decade low of 1 percent to help stimulate a sluggish economy that had rebounded only weakly from the 2001 recession and terrorist attacks. Low interest rates encourage consumers and businesses to borrow and spend, helping fuel economic growth.

Fed policymakers intended to leave their benchmark rate very low for a while to make sure the economy gained strength. Before their meeting in August 2003, Bernanke, then a member of the Fed Board of Governors, said in a speech that he and his colleagues would probably keep the rate low "for a considerable period," signaling that they would leave the rate unchanged.

Financial markets have not been surprised by the outcome of any Fed meeting since. Traders and investors correctly inferred from policymakers' comments that the benchmark rate would stay at 1 percent for a year, until June 2004.

By then, the economy had strengthened to the point that it no longer needed the extra stimulus of low rates, so the Fed started raising them in small, steady steps to 5.25 percent at the last meeting June 29, the longest period on record of continuous credit tightening.

Now, Fed policymakers are divided about what to do. They do not know if the housing market slowdown is going to continue to be "orderly," as Bernanke has described it, or worsen sharply.

They aren't even sure what caused inflation to pick up this year. If the gain is solely due to rising energy prices, then inflation should subside when energy prices level out. In that case, the Fed would not have to raise interest rates much more, if at all.

But if inflation is moving higher because the economy is running too hot -- perhaps because the Fed left interest rates so low for so long -- then the policymakers would have to raise interest rates higher and slow the economy more than they expect.

After a period of extraordinarily cheap money, interest rates are going up around the world. Just yesterday, both the European Central Bank and the Bank of England lifted their benchmark short-term rates in response to higher inflation.

Outlining the upcoming Fed debate, Janet L. Yellen, president of the Federal Reserve Bank of San Francisco, suggested in a speech Monday that she will favor a rate pause when she and her colleagues meet next week at the central bank's marble temple on Constitution Avenue. She noted that it will take time for earlier interest-rate increases to kick in, cooling the economy and suppressing inflation.

"If we kept automatically raising rates until we saw inflation start to respond," she said, "we most likely would have gone too far."

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