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Fed: Which way will economy go?

By Claes Bell, CFA · Bankrate.com
Wednesday, April 25, 2012
Posted: 1 pm ET

Like the economy itself, the Federal Reserve seems to be locked in a holding pattern, waiting to see which way things go.

The federal funds rate remains at a range between zero percent and 0.25 percent, and the Federal Open Market Committee left the estimated date for an interest-rate increase, late 2014, unchanged.

Federal Reserve building

The Fed also declined to offer any new quantitative easing, or QE, initiatives, which lower interest rates on longer-term debt by buying bonds and Treasuries in the open market. From the Federal Reserve statement:

Information received since the Federal Open Market Committee met in March suggests that the economy has been expanding moderately. Labor market conditions have improved in recent months; the unemployment rate has declined but remains elevated. Household spending and business fixed investment have continued to advance. Despite some signs of improvement, the housing sector remains depressed. Inflation has picked up somewhat, mainly reflecting higher prices of crude oil and gasoline. However, longer-term inflation expectations have remained stable.

Lackluster economic data

Given the lackluster economic data that's emerged in the last few weeks though, the FOMC's hesitation to apply more monetary stimulus is understandable, says Kevin Logan, chief U.S. economist for HSBC in New York.

"The employment gains were pretty strong early in the year and it was only (in) the last month and last few weeks that that seems to have tapered off," Logan says. "They will be looking at the average more or less, or the trend. They are not going to react to very short-term data."

With the direction of the economy uncertain, the Fed faces danger on two sides. Should it raise rates too soon, it could choke off the recovery and create a deflationary cycle, where expectations of falling prices lead consumers to delay purchases and hiring. That's exactly what happened in the 1930s, Logan says.

"During the Depression, price levels fell; inflation was negative," he says. "Once prices start falling, people say 'Oh my gosh, I have got to sell my inventory, got to get rid of it. I cannot pay these workers, nobody has any money.' You do not pay your workers, or you cut their wages and they do not have any money, and prices fall some more."

FOMC members disagree on dangers

On the other side, if the FOMC waits too long to raise interest rates, it could overheat the economy and touch off an inflationary spiral, as it did in the 1970s, Logan says.

"Inflation expectations were not anchored, and when we had some oil shocks and food price shocks, inflation went up and it did not come back down, because people did not expect it to come back down," Logan says. "Once inflation went up, it stayed up. People just adopted a routine of, 'Well it is the first month of the quarter, I am going to raise my prices 2 percent.'"

Unsurprisingly perhaps, FOMC members disagree on which is the more pressing concern, says Peter Ireland, a professor of economics at Boston College.

"Given the data, I think no one has a hand that is strong enough to sway one way or the other," Ireland says.

Only time will tell

HSBC economist Logan says the negative economic data that have emerged in the last few weeks, including the biggest drop in orders for durable goods such as airplanes and cars in three years, and news that the United Kingdom and other European economies have officially entered a technical recession, likely gave the latter camp a little more ammo in this meeting.

"I think what you might see in the minutes this time is that members who think of QE3 or an extension of low interest rate policy as a likely outcome are going to be arguing more strongly for that," Logan says. "The more bullish members are going to have to kind of tone their comments down a bit."

The Federal Reserve alluded to this bad news in its statement, saying, "Strains in global financial markets continue to pose significant downside risks to the economic outlook."

But overall, the FOMC still sounded optimistic that the recovery is here to stay:

The committee expects economic growth to remain moderate over coming quarters and then to pick up gradually. Consequently, the committee anticipates that the unemployment rate will decline gradually toward levels that it judges to be consistent with its dual mandate.

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