Fed’s concerns over inflation may lead to bigger rate cuts

By Craig Torres WASHINGTON, Bloomberg

Federal Reserve officials may cling this week to their bias for tighter credit, setting themselves up for bigger interest-rate cuts later in the year if the economy continues to lose momentum. “The Fed is often a little behind the curve when you get to these turning points,” says J. Alfred Broaddus Jr., president of the Richmond Fed from 1993 to 2004. “The reluctance to move toward ease once you have an inflation bias in place may be just a fact of life if you are concerned about credibility.” Chairman Ben S. Bernanke and his colleagues on the Federal Open Market Committee, meeting March 20 and 21, will most likely debate changing their tilt toward higher interest rates. They may even add language to their statement underscoring their concern about weakening economic conditions, economists say. That would allow them to set up expectations for a change in their rate outlook in case the economy deteriorates more than expected. The Fed will be reluctant to go further because Bernanke and at least six other FOMC members are on record as saying they want inflation to slow to between 1 percent and 2 percent. The Fed hasn’t achieved this goal since March 2004, almost two years before Bernanke became chairman.

“They are the new kids on the block,” says Paul Kasriel, director of economic research at Northern Trust Securities in Chicago. “This committee has to be very careful about its credibility.” The cost of defending their stance may be a deepening slowdown in the economy this year, one that will force the central bank to loosen credit more than it otherwise would have, says Dominic Konstam, head of interest-rate strategy at Credit Suisse Holdings in New York. “The longer the Fed remains on hold, the more likely it will have to cut rates, and by more, later,” says Konstam. Some Fed-watchers speculate that the central bank’s bias would quickly change if its internal forecast called for a dramatic slowdown in growth and inflation. While the forecast is a secret, there’s little to suggest the Fed has reason to change its view that inflation remains the predominant threat. Published economic indicators show that inflation pressures persist, while signs of economic distress aren’t widespread.

The consumer price index minus food and energy rose 2.7 percent for the 12 months ending February, the Labor Department said March 16. That so-called core CPI these days measures inflation at about half a percentage point above the gauge Fed officials prefer, the core personal consumption expenditures price index. The core PCE rose 2.3 percent for the 12-month period ending January. Forecasters, including those at the Fed, aren’t good at predicting turning points in the economy. One reason: Asset wealth and credit play an increasingly important role in spending, and conditions can change almost overnight. Stock prices can rise and fall rapidly, and credit availability can dry up within days. “If you don’t include asset prices in your analysis of overall inflationary trends, you tend to be too accommodative when prices are rising and too restrictive when prices are falling,” says Joseph Carson, director of economic research at AllianceBernstein Holding LP in New York. Right now, the Fed is “too restrictive,” he says.