WASHINGTON – A combination of scant inflation and still-modest U.S. economic growth will likely lead the Federal Reserve this week to maintain its drive to keep borrowing costs at record lows indefinitely.
The Fed has said it plans to keep its key short-term interest rate near zero at least until the unemployment rate dips below 6.5 per cent from its current 7.6 per cent.
It’s also been buying $85 billion a month in Treasurys and mortgage bonds to try to keep long-term borrowing rates down. The goal has been to energize the economy through more consumer and corporate borrowing.
In recent months, many economists had suggested that the Fed might scale back its bond purchases in the second half of 2013 if job growth accelerated.
But the jobs report for March was surprisingly weak. And inflation has been running below the Fed’s target rate, allowing it to keep stimulating the economy without igniting price increases.
“I am not looking for any major action from this meeting,” says David Jones, an economist at DMJ Advisors.
The Fed’s interest rate-setting committee will begin a two-day meeting Tuesday and will issue a policy statement once its meeting ends Wednesday afternoon.
The minutes of the Fed’s last meeting in March suggested that some policymakers favoured slowing and eventually ending its bond buying — as long as the economy and the job market kept improving. Some feared that keeping rates too low for too long could escalate inflation, fuel speculative asset bubbles or unsettle markets once the Fed has to start raising rates or unloading its record $3 trillion investment portfolio.
Early this month, though, the government said U.S. employers added only 88,000 jobs in March, far below the 220,000 average in the previous four months. Last week, it said the economy grew at an annual rate of 2.5 per cent in the January-March quarter — a decent growth rate but one that’s expected to weaken in coming months because of federal spending cuts and higher Social Security taxes.
At the same time, consumer inflation as measured by the gauge the Fed most closely monitors remains well below its 2 per cent target. That gauge rose just 1 per cent in the 12 months that ended in March.
Analysts now think the Fed will keep the Fed’s easy-credit policies unchanged, possibly for the rest of the year.
“The government’s fiscal austerity is kicking in and hitting the economy hard,” says Mark Zandi, chief economist at Moody’s Analytics. “I am not looking for any change in Fed policy at this meeting, not with this weak growth and low inflation.”
After years of debate, the Fed in January 2012 followed the lead of many other central banks around the world in establishing an inflation target of 2 per cent. The Fed’s goal is to keep price changes from hurting the economy.
This could occur if inflation raged out of control or if the opposite problem — deflation — emerged. Deflation is a prolonged drop in wages, prices and the value of assets like stocks and houses.
The United States last suffered serious deflation during the Great Depression of the 1930s. But Fed policymakers think the risks of deflation can rise as inflation dips below 2 per cent. They want to avoid following the path of Japan, which has struggled with weak growth and deflation for more than two decades.
Economists don’t think the latest economic data will lead the Fed to step up the size of its bond purchases. But they say the figures should embolden the majority of officials who back Chairman Ben Bernanke’s commitment to keep borrowing rates down until the economy shows sustained improvement — as long as inflation stays low.
“The Fed can’t wink, scratch its nose, wiggle its ears or do anything that would signal they are about to change policy from what they are doing now,” says Brian Bethune, an economics professor at Gordon College in Wenham, Mass. “That would be totally premature.”
Bethune says the Fed needs to be especially cautious in signalling any policy shift because the U.S. economy has been serving as a global engine of growth. Many European countries are still struggling to escape a recession that followed the region’s debt crisis.
“Anything the Fed did that could disrupt things or create uncertainty could tip the whole global economy back into recession,” Bethune says.
Few expect the central bank to start raising short-term rates before late 2015 or early 2016. And many economists think the Fed will keep buying $85 billion in bonds each month for the rest of this year, before starting to curtail its purchases in early 2014.
Still, some analysts say that if the economy emerges from a slowdown caused in part by the government cuts and starts accelerating, the Fed might taper its bond purchases by fall.
Whenever the Fed does decide to signal a potential pullback of its aggressive credit easing, after a long period of record-low rates, analysts say the shift could jolt investors.
“No one can predict how much financial market instability we are likely to get when the Fed finally begins pulling back,” Jones says.