Federal Reserve more Optimistic on Prices

Scott Lanman and Steve Matthews, Washington
October 27, 2006

FEDERAL Reserve officials may leave interest rates alone until the middle of next year, confident of moderate economic growth and abating inflation pressures.

Futures traders anticipate the Fed's benchmark lending rate will stay at 5.25 per cent until May, and yesterday's prediction by policymakers of a modest expansion reinforced those predictions.

The Federal Open Market Committee, which left its rate unchanged for a third month, also ceased describing energy prices as a source of inflation danger.

"The Fed funds rate at 5.25 is growing roots and doesn't appear likely to change any time soon," said Stuart Hoffman, chief economist at PNC Financial Services Group in Pittsburgh. He said the Fed's view "implies the economy will go to stable growth or even slightly better economic growth" after slowing in the third quarter.

Fed chairman Ben Bernanke, in his first year at the helm, is aiming to guide the US economy to a soft landing after ending a two-year credit tightening in June. The growth outlook the committee provided in the post- meeting statement was the first since May.

"Economic growth has slowed over the course of the year, partly reflecting a cooling of the housing market," the statement said. It said the economy "seems likely to expand at a moderate pace".

Goldman Sachs Group economists estimate the economy's potential growth rate to be about 3 per cent a year.

The gamble is that interest rates may not be high enough to nip inflation. The Fed's preferred price gauge, year-on-year, has run above the comfort zone of Mr. Bernanke and other officials for more than two years. The committee forecast in July that inflation next year would remain at least at 2 per cent, the upper end of the acceptable range.

The "moderate pace" outlook reflects recent remarks from vice-chairman Donald Kohn, who was former chairman Alan Greenspan's chief monetary strategist before joining the board of governors in 2002.

"The economy will grow at a moderate pace for a while, somewhat below the rate of increase of its potential, and then growth will begin to strengthen," Mr. Kohn said in an October 4 speech in New York. As pressures on energy and materials prices eased, "we will likely see much lower headline inflation and a gradual diminution of core consumer price inflation", he said.

The press release also eliminated a reference to high prices of energy and commodities, making it the first time since June 2005 that the central bank did not characterize fuel costs as "high" or "elevated". Bonds rallied and the dollar weakened.

"The Fed has described the scenario in which they're very comfortably on hold," said Mickey Levy, chief economist at Bank of America in New York. "Moderate pace" represented a drop to "below-trend-like growth, but not any kind of hard landing, not a sharp slump".

The Fed has not been unanimous. Richmond Fed president Jeffrey Lacker cast his third straight vote against holding interest rates steady, becoming the first Fed policymaker to dissent at least three consecutive times since 1998.

"They are really betting on the economy slowing down enough to slow inflation, even though at this point there are no signs that inflation is slowing," said Edgar Peters, chief investment officer at PanAgora Asset Management in Boston.

Source: BLOOMBERG