Threading the Needle at the Fed

By Desmond Lachman

The recession is ending but big risks remain.

At its forthcoming meeting on September 22 and 23, the Federal Reserve’s Open Market Committee (FOMC) will have to perform a very delicate balancing act. It will need to maintain its highly accommodative and unorthodox monetary policy stance in order to provide support to the incipient yet fragile U.S. economic recovery. However, it will also have to assure the financial markets that the Federal Reserve remains vigilant about potential inflationary risks and that it stands ready to exit from its policy of extraordinary monetary policy easing at the first sign that the economic recovery is gaining traction.

The FOMC can be expected to confirm that the economic recession has at last ended. However, it will likely allude to the remaining risks that could threaten the recovery once the present support to the economy from the fiscal stimulus and inventory rebalancing fades. The risks that the Fed might highlight include the pronounced weakness in the U.S. labor market and the ongoing bursting of the U.S. commercial real estate bubble.

The FOMC is likely to indicate that the present very large gaps in the output and labor markets should keep inflation well contained in the year ahead. However, it will intimate that inflation developments will need to be carefully monitored especially if the U.S. dollar continues to weaken.

In terms of policy actions, one should expect that the FOMC will maintain its 0–0.25 percent federal funds rate target and it will repeat that it expects to maintain the federal funds rate at this level for an extended period of time. The FOMC is also likely to intimate that it does not intend to expand its quantitative easing program beyond the planned purchase of $300 billion in U.S. Treasury bonds and $1.25 trillion in mortgage-backed securities that it has already announced.

Among the indicators on which the FOMC will be focusing are the following:

(a) Signs that the cycle of inventory liquidation has run its course and that manufacturing output has begun to recover.

(b) Indications that consumer confidence has bottomed out albeit at a still very depressed level.

(c) Tentative signs suggesting that the U.S. housing market is finding a bottom and that new housing construction is beginning to recover.

(d) Clear indications that the financial markets are continuing to heal and that the equity market rally since March 2009 is at least partially reversing the $14 trillion in household wealth destruction over the past two years.

(e) Data showing that unusually large gaps have opened up in the labor and product markets and that the process of labor shedding is yet to have finally run its course.

(f) Clear indications that the large gaps in the labor and output markets are exerting significant downward pressure on prices and wages, which is keeping long-run inflation expectations well contained.

(g) Strong indications that consumer credit expansion is being scaled back to a considerable degree.

(h) Clear indications that the commercial property market is in the midst of a severe contraction.

(i) Troubling indications that the dollar remains under considerable pressure.

Desmond Lachman is a resident fellow at the American Enterprise Institute. Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney.