News & Analysis » US

The Fed Outlook: A Delicate Endgame

Contributed by Raymond James

By Scott J. Brown

Federal Reserve policymakers meet this week to set monetary policy. While nobody expects the Fed to raise short-term interest rates anytime soon, the Fed will have a variety of new tools available to tighten policy in this cycle. In the months ahead, we’re likely to hear more details about which tools the Fed will use and in what order (sequentially or in combination). The Fed has time to gauge the expected strength of the recovery, but will also have to incorporate uncertainties.

Recessions are not merely the economy slowing down and then speeding back up. There is substantial structural change going on. Most jobs that are lost are unlikely to return. Consumer spending habits and inventory management are also changing. Figures on retail sales suggest a shift to a lower consumption path, which corresponds to an increase in the personal savings rate. Surveys indicate that households have cut back on discretionary spending, increasing savings or paying down debt. The adjustment to the new spending path is transitory. The new path appears slower than before, but that’s partly a consequence of a weak labor market.

Inventories tend to grow in line with sales over time. Improvements in inventory management and a push toward holding inventories overseas has dampened the inventory cycle in the U.S. Inventories have been a smaller factor in recent recessions. However, in the recent recession, the inventory cycle has been much more apparent. As sales slow, inventories rise, then fall to be more inline with the pace of sales. This inventory cycle appears to have come full circle. Inventory to sales ratios are nearing their pre-crisis levels.

On Friday, the government will report its initial estimate of fourth quarter growth. The advance estimate will be based on assumptions regarding December foreign trade, inventories, and other components. A slower rate of inventory reduction will make a large contribution to 4Q09 GDP growth. Remember, it’s the change in inventories that contributes to the level of GDP. The change in the change in inventories contributes to GDP growth. Inventories don’t have to rise to add to GDP growth, they simply have to fall at a slower rate. There’s some chance that we could see a small inventory build in the inflation-adjusted numbers, in which case the GDP estimate will be even higher (some estimates on the Street are more than 5%). However, excluding inventories, fourth quarter GDP growth is likely to be relatively lackluster. So don’t get too excited about the headline figure. Domestic Final Sales (GDP less inventories and net exports) are a better measure of underlying demand.

The fourth quarter GDP figures tell us little about growth in the current quarter and beyond. The recovery should continue to build over time, but there are still a number of significant headwinds in the near term. Fed officials realize this, which will keep them from raising short-term interest rates anytime soon.

There are a number of uncertainties in the outlook, which makes it difficult to set monetary policy. Inflation should not be a problem. There’s no pressure coming through the labor market, the widest channel for inflation. High government budget deficits do not cause inflation (see: the Reagan years).

Importantly, the Fed will have a number of new tools at its disposal as it tightens. Officials have already begun to unwind the special liquidity and lending facilities. The Fed now pays interest on bank deposits held at the Fed and can discourage bank lending by raising that rate (but why would they do that in the foreseeable future?). If inflation were to become a more immediate concern, the Fed could sell its holdings of Treasuries and mortgage-backed securities, but that would likely be disruptive to the financial markets. It would be easier to do reverse repos (something that the Fed has already tested). An increase in the Fed funds rate is likely to come later. The Fed’s decision to tighten will be driven by job growth, and the trend in core inflation (which has remained low).