Further Fed Tightening Forced, May Not Be Warranted

Scrutiny of the U.S. Federal Reserve concerning its actions ? and the words of Chairman Ben Bernanke ? will persist as the Fed looks to continue its economic tightening at the end of the month, according to economic analysis from global trade credit insurer Euler Hermes ACI.

Chief Economist Dan North ? whose primary responsibility is to use macroeconomic and quantitative analyses to manage Euler Hermes ACI?s risk portfolio ? recently authored an economic commentary piece titled ?Tough Times at the Fed? concerning the Federal Reserve meeting June 28-29. The following is an excerpt from North?s commentary:

?The Federal Reserve has become the focus of intense scrutiny in the past few weeks, over both its actions and its words. It is often thought that the Fed controls monetary policy simply by setting the Federal Funds rate, but the Fed has another powerful tool. It can use ?jawboning? ? or making public speeches and comments to influence consumers, financial markets, and the economy as a whole. While the recent use of the Fed Funds rate may have been fine, the use of the jawboning tool has been disastrous.

(Recent) remarks were no doubt intended to make it perfectly clear that the Fed will tighten at the June 28th and 29th meeting, and they were meant to bolster both the Fed?s and Bernanke?s credibility as inflation fighters. So the Fed now has to raise rates, no matter what happens between now and then. It has painted itself into a corner. There is even the possibility that the Fed may choose to emphasize the message by raising the Fed Funds rate by 50 bps instead of the usual 25 bps.

The action to raise rates will be a symbolic one made to signal credibility, but the economic fundamentals might actually dictate that the Fed should stop raising rates now. Readings on inflation are mixed. The Consumer and Producer Price Indexes, and inflationary expectations data do show some upward pressure, most likely the result of persistently high energy prices working through the economy. But this data should be balanced against Unit Labor Costs rising only 0.3% in the past year, the Employment Cost Index growing at only 2.8% in the past year which is the lowest rate in nine years, hourly wages growing only $0.01 last month which is the lowest in seven months, the price of gold which has fallen 15% in three weeks, and the price of crude oil which has fallen 5.7% in the past four weeks.

And while inflation data is mixed, there is surely evidence that the economy is slowing down. May?s Employment Report and Credit Manager?s Index were emphatic about a slowdown, and signs of a softening consumer and housing market continue to emerge. It is critical to note that actions taken by the Federal Reserve can take a year or more to work through the economy. With June?s rate hike, the U.S. economy will have to proceed through another full year with the brakes on, and the economy is already slowing.

The Federal Reserve surely has a difficult and tricky job to do. Balancing inflation and growth now is hard enough, but balancing inflation and growth in the future is the real job. Furthermore, the tools for managing this challenge, jawboning and interest rate changes, are certainly double-edged swords. Jawboning has just cut the Fed the wrong way, first hurting credibility, and now forcing it into action which might not be warranted by the fundamentals.?