GuestView Fed holds steady, but changes emphasis in language By PETER GIOIA

GuestView
Fed holds steady, but changes emphasis in language
By PETER GIOIA

On the afternoon of Aug. 7 the Federal Reserve Bank’s Open Market Committee held the federal funds rate steady at 5.25 percent, effectively keeping the prime rate constant. But the committee shifted its emphasis from potentially raising rates to neutral in language announcing the decision.

This was the expected action forecast by a large consensus of the economic community. The question remains, though, whether it is the right decision. Overall, the economy, on average, appears to be growing at a moderate rate with modest improvement in core inflation. As the Fed says in its statement, “Although the downside risks to growth have increased somewhat, the committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the outlook for both inflation and economic growth, as implied by incoming information.”

In short, this means inflation is still the Fed’s major concern, not growth.

The Fed view on the economy is, “Economic growth was moderate during the first half of the year. Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.”

However, the “moderate growth” masks growing imbalances at two extremes coupled with concern over a “credit crunch.” On one hand international business is booming with great result for U.S. multinationals and even small firms fully exploiting the export markets. That’s great news for companies involved in manufacturing, shipping and supply-chain operations as well as a lot of international-heavy financial services operations.

On the downside the subprime mortgage area is hemorrhaging and its impact is spilling into mainstream residential real estate. This also hurts all firms that support residential construction such as home improvement, builders, real estate agents and home-related manufacturing. In addition, it is impacting consumer confidence leading to concern about future consumer spending, especially consumers with below-median incomes. Furthermore, the subprime impact on international finance has raised the possibility of a widespread credit crunch that could potentially suffocate now robust B2B activity.

As late as midyear, economic consensus still had all engines firing strongly in the U.S. economy into 2008; now we see real revision and rethinking of the economy’s potential. Some areas of the nation, notably Florida, are already listed as “in recession” by economic consultants like Moody’s economy.com.

The economy has shown great resiliency and recent panic should not lead people to think a recession is inevitable, even if very bad things continue to surface in the subprime debacle. We see here in Connecticut solid job numbers and nationwide employment is very positive. Jobs mean income growth and that coupled with excellent global business news could well keep us out of the red through 2008, though at rates of growth somewhat below earlier forecasts of 3 percent to 3.5 percent gross domestic product from major economic consulting firms.

Nevertheless, the subprime problem is real and widespread. The Federal Deposit Insurance Corp. believes at least $200 billion of subprime mortgages are heading for foreclosure and Moody’s economy.com estimate is double that of the FDIC. Either number will mean some real suffering. Fed actions usually take about six months to fully become absorbed into the economic mainstream. In early February 2008 we all may well wish the Fed took a chance and cut rates to stimulate an economy that may yet not be in recession, but is slow enough and cold enough that it feels like it is.

Peter Gioia is a vice president and economist at the Connecticut Business & Industry Association in Hartford. Reach him at gioiap@cbia.com.

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