Fed Leaves Door Open to Future Rate Increases

Ben S. Bernanke and other bank leaders want to remain flexible.
Ben S. Bernanke and other bank leaders want to remain flexible. (J. Scott Applewhite - AP)
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By Neil Irwin
Washington Post Staff Writer
Thursday, July 31, 2008

The Federal Reserve is all but certain to leave interest rates unchanged when it meets next week, and its leaders are disinclined to raise them in the immediate future. But they almost uniformly think that the next time they adjust rates, it will be to raise them, and the debate behind closed doors next week will probably center on how and when to do that.

The economy and financial markets have grown shakier since Fed policymakers last met in late June, and oil prices have fallen some. But Fed officials think that the dramatic rate cuts they undertook in the first half of the year are probably sufficient to keep growth from falling off a cliff and that the bank has been vigilant enough in using other tools to protect the financial system that it could raise interest rates without causing a resurgence of the crisis.

Those tools were on display yesterday, as the central bank took more steps to help make sure banks and other financial institutions don't encounter a cash crunch at the end of the year. It will extend the ability of investment banks to take out emergency loans at its discount window until January, among other steps it announced yesterday.

There are two basic scenarios in which the central bank would raise rates, both aimed at choking high inflation. In one, economic growth continues to muddle along, as it has throughout the year, with unemployment rising modestly and no disastrous recession taking hold. In that scenario, Fed policymakers would eventually have to raise the federal funds rate above the current 2 percent to avoid overstimulating the economy.

In the second scenario, which could result in rate increases sooner than that, the Fed would be forced to act because of rising expectations for inflation -- reflected in further sharp drops in the dollar, big new increases in commodity prices or an increase in inflation expectations as measured by the bond market. In those instances, the Fed would act to show its seriousness about keeping inflation contained in the long run.

Even among key policymakers, including Chairman Ben S. Bernanke, there is uncertainty because of the simultaneous slumping economy, complex financial crisis and a spike in the price of oil and other commodities. Central bank leaders are seeking to remain flexible by not committing to any particular policy in the months ahead.

"Growth seems likely to slow in the second half of the year, so it makes sense to wait and see how things are going before raising rates," said Peter Hooper, chief economist of Deutsche Bank Securities. "At the same time, if those inflation numbers begin to get worse, they recognize they may have to move sooner rather than later."

Several presidents of regional Federal Reserve banks, who sit on the policymaking Federal Open Market Committee, have indicated a desire to respond more aggressively to the threat of inflation, including the presidents of Federal Reserve banks in Philadelphia, Dallas, Richmond and Kansas City, Mo.

More so than Bernanke and other Fed policymakers, they think that there is a high risk that Americans will lose faith in the central bank's resolve to keep prices stable and that if the Fed does not raise rates preemptively, there could be a 1970s-style wage and price spiral.

Most of those on the policymaking committee, though, note that wages have been rising slowly, and they are more focused on the levels of inflation today and what is expected for tomorrow based on surveys and financial market indicators.

But lately, Fed leaders who are viewed as more worried about the weaker economy have expressed heightened concern about inflation, including the presidents of the Fed banks in San Francisco and Minneapolis. The risks of inflation, "have definitely increased," San Francisco Fed President Janet Yellen said in a speech this month. "We cannot and will not allow a wage-price spiral to develop."

One big question is whether the Fed should consider a one-time increase in the federal funds rate, its main policy tool. That rate has been unchanged at 2 percent since the end of April after a series of cuts that began last fall.

In general, Bernanke prefers to begin raising rates only when he is committed to an extended period of increases. That would mean waiting until the economy appears to be on solid footing. But Fed leaders see the use of a one-time bump in interest rates, such as one recently made by the European Central Bank, as potentially having some effect when markets are at risk of losing confidence in the central bank's inflation-fighting credibility.

"If Fed credibility looks a bit shaky, with a weak dollar and high inflation expectations, a one-off rate hike could be a way to shore up your credentials," said Michael J. Feroli, a U.S. economist at J.P. Morgan Chase.

The challenge would be to communicate to the markets that such an increase was not the beginning of a series. The Europeans struggled with that issue before their increase at the beginning of the month.

"Over the course of the last couple of weeks, the situation has gotten shakier on the growth front, but we still think it's a feasible option," Feroli said of a one-time hike. "They just have to telegraph it well enough."

The steps the Fed took yesterday to deal with liquidity were the latest in a string of measures, begun last August, to keep cash flowing through the troubled financial sector. It expanded the "term auction facility," which lends money to banks, to include longer-term loans.

And the Fed said it would start selling investment firms options to obtain future liquidity, a move similar to one taken in 1999 in anticipation of a potential cash crunch surrounding Y2K. That move would allow firms to bolster their ability to weather the cash crunches that have occurred at the end of each quarter and year.

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