Fed likely to hold rates, stay focused on inflation

WASHINGTON: When Federal Reserve officials meet next week, they will do what they have done at four previous policy-making sessions: leave the overnight lending rate at 5.25% and say they are more concerned about inflation than possible economic weakness.

A few weeks ago, many financial analysts were predicting that slowing growth would prompt the Fed to adopt more neutral language at the January 30-31 meeting in preparation for reducing the target in March or May.

That prediction was a major misreading of Fed thinking. With labor markets tight and the inflation rate still somewhat elevated, officials on the Federal Open Market Committee simply weren���t thinking about reducing the target.

Now, according to the interest rates implicit in federal funds futures contracts, investors are no longer looking for a rate cut anytime in the next six months. On the other hand, economists at Goldman Sachs Group haven���t abandoned their forecast of 75 basis points of rate reductions in 2007, beginning by midyear. They have told their clients, though, that won���t happen unless monthly payroll job gains drop to about 50,000 a month, or there is at least a moderate increase in the unemployment rate. Their counterparts at Macroeconomic Advisers, who don���t expect any such slowing in job growth, said in their weekly forecast update on January 19 that they ���expect the Federal Reserve to maintain the fed funds rate at 5.25% throughout 2007���.

They went even further, adding: ���The next decision for the Fed will be whether to resume tightening or to remain on hold, given the economy���s apparent resiliency and the upside inflation risks emanating from tight labor markets.���
That���s not a decision that is going to be on the table next week, however. A number of Fed officials have indicated in recent speeches that they are quite comfortable with the current 5.25% target, among them Fed governor Susan Schmidt Bies.

In a speech in Arizona on Jan. 18, Bies said, ���All things considered, the scene appears to be set for a deceleration in prices.��� Janet L Yellen, president of the San Francisco Federal Reserve Bank, said much the same thing in a January 17 speech, which she repeated on January 22. ���I have supported the decision to hold policy steady at the current rate,��� Yellen said. ���That may seem a little surprising, given that inflation remains higher than I would like it to be and that there are some upside risks to my inflation outlook. ���Let me be clear that I do want inflation to move down, but I believe policy may now be well-positioned to foster exactly such an outcome while also giving due consideration to the risks to economic activity,��� she said.

One of those risks, of course, is that the low 4.5% unemployment rate could give rise to new inflationary pressures. Yellen said she doesn���t think that will prove to be the case. Still, the jobless rate is lower than she and other Fed officials had expected it to be at this point, and monthly payroll job increases ��� which come from a separate survey of businesses rather than households ��� have been larger than expected. The number of payroll jobs rose a seasonally adjusted 167,000 in December, with an average monthly increase in the fourth quarter of 139,000. That was down from an average of 185,000 in the July-September period, though still well above the 100,000 or so many Fed officials believe is enough to absorb new entrants into the civilian labor force.

Warmer-than-normal weather may have boosted December���s seasonally adjusted figure ��� and a similarly warmer first half of this month may have the same effect, some analysts have noted. Fed officials were puzzled about the strength of the US labor market before December and remain so.

Nevertheless, they are under no pressure to alter the waiting game they have been playing since they decided last August not to raise the lending rate target for the first time after increasing it 17 consecutive times in just over two years.

As Yellen, Bies and several other officials have said recently, inflation expectations remain at a low level and there are signs that inflation is decelerating. For instance, while core inflation ��� which excludes food and energy prices ��� was 2.6% in the 12 months ended in December, it rose at a 2% annual rate in the latest six months and at only a 1.4% rate in the October-December period. None of the officials is yet convinced that inflation will slow to a more acceptable level, and that���s why the FOMC policy statement next week will reiterate the concern about inflation.

Meanwhile, on the growth side, concern that the major weakness in the housing sector would spread to other parts of the economy have so far not been realised. And as some stronger figures were reported for December, many forecasters have been raising their predictions for fourth-quarter gross domestic product.

The advance estimate for that number will be reported by the Commerce Department on January 31, shortly before the FOMC makes its policy decision. It isn���t likely to affect the outcome because it will be just one more data point among many.