As economy hits stride, Fed drags feet
By Greg McBride, CFA • Bankrate.com

Five words. The Federal Open Market Committee statement issued following the Oct. 28 policy meeting changed by just five words compared to the statement issued Sept. 16.

Despite continued evidence of economic improvement, including the first hint of long-awaited job growth, a mere five words were all the FOMC felt compelled to alter since the last meeting. Specifically, the FOMC did acknowledge the initial evidence of improvement in the job market, changing from " ... although the labor market has been weakening" in September, to " ... and the labor market appears to be stabilizing" on Oct. 28.

Such is the dilemma of seeing the economy finally hit a decent stride, but sustaining the low interest rates that have been, and will continue to be, a tailwind to economic progress.

The latest Fed mantra is the notion of maintaining low interest rates for a considerable period, an assurance that the Fed will not be in any hurry to boost interest rates at risk of jeopardizing the economic rebound. The Fed has repeated the message about not intending to hike rates until they are absolutely compelled to do so, most likely if inflation, as the Fed sees it, begins to take off. The message is further cemented by the Fed's ongoing concern that a decline in the rate of inflation may still present itself. In the past five post-meeting FOMC releases, a potential decline in inflation has been cited as a predominant concern.

But look closely enough and you can find a few cracks in this assertion. A pickup in the Consumer Price Index vs. one year ago has gone largely unnoticed by the FOMC and financial markets. Consumer prices are currently up 2.3 percent over one year ago, well ahead of the 1.6 percent annual pace that prevailed one year ago. Instead, focus has long centered on the rather benign level of inflation, or outright deflation, seen at the producer level over the past couple years. Preliminary postings indicate that even here, prices are beginning to rebound from the depressed base of one year ago, though the numbers are subject to further revision.

The initial estimate of third quarter Gross Domestic Product showed a staggering 7.2 percent annualized jump over the second quarter, which had been up 3.3 percent over the first quarter. This is a sparkling result by anyone's measure, but also worth noting is the fact that the employment cost index and the GDP deflator, both of which provide an indication on price levels, were higher than expected. While still posting only moderate increases, the matter of outpacing expectations is not to be ignored, especially for those that buy the argument about the risk of inflation declining further.

The FOMC has historically looked to GDP deflator as an indication of overall inflation. Having faster-than-expected economic growth with no acceleration in prices is a condition that cannot be sustained, regardless of the current slack in the employment and production markets. If the Fed intends to keep interest rates low into next year, then the potential for inflation will also exist into next year. Continued economic expansion and a steady uptick in prices will mean that even the staunchest deflation hawks at the FOMC will have little inflation birds chirping in their ears.

Validation as to whether the labor market is finally on the road to improvement, or is merely stabilizing, will come with the Nov. 7 release of the monthly employment report. Forecasts are for a second consecutive month of modest job growth on the heels of September's 57,000 new jobs, a number also due to be revised. The evidence provided by weekly unemployment claims indicates improving conditions, as initial claims have dropped below and stayed below 400,000.

The FOMC statement reflects the dilemma of keeping interest rates low as the economy hits its stride. While acknowledgment of the economic improvement is warranted, pledging to maintain historically low interest rates despite a robust economic expansion requires ignoring something, whether it is price levels, the sustainability of growth, or the job market outlook. Poker face or not, inflation may ultimately call the bluff.

Greg McBride is a financial analyst for Bankrate.com.

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