The Hindu Business Line : FOMC: Pause on the cards

It is almost certain that the FOMC will put rates on hold at this meeting, reserving the option to raise if the inflation numbers worsen. A slowing economy would even justify a cut if the trend continues.

Fed watch is again the theme of the week as the Federal Open Market Committee (FOMC), which sets US interest rates, meets.

Six weeks (approximately) — which is when the FOMC last met — can make a world of a difference. The odds then were for a continuation of the rate rises of 25 bps at each meeting, set in motion from June 2004. All of a sudden, the talk is of a pause at the current meeting.

Mr Ben Bernanke, the Fed and FOMC Chairman, has been hinting at the possibility of at least a temporary halt to the non-stop increases in interest rates for more than the last two years.

The Fed has never in the past raised rates consecutively in as many as 17 meetings.

Normally it would have killed off the US economy, perhaps for good. But, this time the conditions surrounding were distinctly different.

Greenspan strategy

Mr Alan Greenspan, Bernanke's predecessor, cut rates to a historic low of 1 per cent and what is more kept it there for quite some time.

Post-September 11, sagging business and consumer confidence were badly in need of adrenalin.

Mr Greenspan also feared deflation — falling prices — would overtake the economy, as it had in Japan. Mr Bernanke, then a member of the FOMC — shared Mr Greenspan's view.

Rates had to go up sometime and they did. The process of `normalising' rates began.

How high did they have to go before they became `normal'? There was no unambiguous answer.

The goal was to reach a `neutral' rate, when monetary would be neither stimulative nor accommodative and inflation would be within acceptable limits.

It is a concept that is more easily described than implemented (although Taylor's rule heroically tries to answer the knotty question of what the `right' interest rate is, given actual output and inflation and the desired mix of the two).

The reality is that the American economy, going by the latest data, is unwinding faster than possibly the Fed expected. Q2 GDP was weaker than forecasts and job creation has been anaemic for the last two months.

There is a perceptible slowdown in the locomotive of growth in the last few years — housing. Add to this the woes from rising energy prices and inflation and it is clear that the misery index is rising.

It is almost certain that the FOMC will put rates on hold at this meeting, reserving the option to raise if the inflation numbers worsen.

Its job will not be made easy by the slowing economy, which would justify a cut if the trend continues.The problem is with the `lagged and variable effects of monetary policy'.

Such is the state of knowledge about how economies work that all the high-powered research in the best academic environments has so far failed to enlighten central banks on how and when precisely their interest rate decisions will impact growth, inflation and employment.

That perhaps is why the ECB refuses to look at anything beyond inflation and money supply in its interest rate decisions.

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