Fed's job will be easy next week
By Lyle Gramley • Bankrate.com

Lyle E. Gramley, a Federal Reserve Board governor from 1980 to 1985, wrote this commentary for Bankrate.com.

The U.S. economy is finally on a roll. Consumer spending is rising strongly; businesses capital spending has joined the parade, and outlays for defense are increasing dramatically.

Inventory investment has yet to kick in, but it soon will, as stocks are lean and businesses will need to add to inventories to accommodate rising final sales. After 3 percent growth in the second quarter, the pace of expansion is stepping up to 5 percent or better in the third, and the fourth quarter will be another strong one. Payroll employment has yet to turn up, but it will by the fourth quarter as businesses gain confidence that the economy has come out of the doldrums.

Economy on a roll
Economic expansions, once well under way, develop a good deal of dynamism. Increased job opportunities strengthen consumer confidence, encouraging consumers to spend more. Businesses, experiencing increasing sales and profits, invest more aggressively in both inventories and fixed capital. Rising corporate profits are bullish for the stock market, and higher stock prices boost both business and consumer spending. The expansion feeds on itself, creating a self-sustaining momentum. There is every reason to think that the economy's newfound momentum will keep growth at a robust pace throughout next year.

What has prompted this renewed strength of the economy?

Tax cuts and rising federal spending are part of the story. Also, we have put behind us most, though not all, of the effects of the bursting of the bubbles in the stock market and the high-tech industries. Jitters regarding the invasion of Iraq have been quieted, and consumer confidence has risen.

Bravo FOMC
But a good part of the credit goes to the Federal Reserve. Interest rates have been brought down to the lowest level in 40 years. The benefits have been particularly evident in the housing and mortgage markets. Housing starts are on a path to hit the highest level this year since 1986, and the volume of mortgage refinancings in 2003 will probably reach $2.25 trillion. That has provided a huge support for consumer spending; some homeowners have lowered their monthly mortgage payments, while others have extracted equity from their homes to spend on goods and services or to pay down credit card debt.

Absent a major setback to the economy, the Fed has finished lowering interest rates for this business cycle.

Growing economy = more jobs = more spending
Is there something that could derail the economic locomotive? Some people worry that the lack of job creation could do it. I doubt it. One reason why jobs haven't been created is that the economy hasn't been growing fast enough. The newfound strength in evidence recently will take care of that. The other reason is that productivity growth has been exceptionally strong. But overall economic growth facilitated by strong productivity gains adds to someone's income, and that tends to feed back in one way or another to more spending.

A major outbreak of domestic terrorism -- heaven forbid -- could cause consumers to hibernate out of fear for their safety. Barring that, there is little reason to expect the Fed to step on the monetary accelerator pedal yet another time.

Indeed, the bond market has begun to focus on quite the opposite question: When will the Fed have to start raising interest rates to avoid inflation? It is not an idle question. After all, interest rates are abnormally low and cannot stay there forever.

When will rates rise?
Fed policy officials have given us every reason to think that the first increase in short-term interest rates is a long ways off -- stating in the Aug. 12 press release their belief that "... policy accommodation can be maintained for a considerable period." The basis for this judgment is the remarkably favorable outlook for inflation.

Over the next several quarters, inflation is more likely to go down that up. Slack in the economy is one reason. History indicates that idle labor resources and excess capacity in manufacturing put downward pressure on prices. Global competition remains intense, curtailing business-pricing power. The strongest source of downward pressure on costs and prices is coming from phenomenal increases in productivity. Over the past year, productivity has risen by 4.1 percent, while compensation per hour has risen by just 2.9 percent. Consequently, unit labor costs have fallen by 1.2 percent.

I don't suppose such outsized gains in productivity can continue indefinitely, but there is no evidence that they are soon to abate dramatically. The Fed has more to worry about slipping inadvertently into deflation -- an outright decline in overall prices -- than it does about an undesired rise in the inflation rate.

The Fed's job next week is an easy one. They will leave interest rates unchanged. The improved outlook for the economy will be noted in their post-meeting announcement. But I expect them to stick with the statement that the risk of inflation becoming undesirably low is the predominant concern for the foreseeable future. Maybe the statement of risks will become more balanced before year-end. But I don't expect the Fed to start raising interest rates until after the middle next year.

Lyle E. Gramley is the senior economic adviser of the Schwab Washington Research Group. He spent the bulk of his professional career with the Federal Reserve, and was a governor of the Federal Reserve Board from 1980 to 1985.