Fed Likely to Go Slow on Interest Rate Policy

Although the Federal Reserve this week has signaled a slight relaxation of its grip on credit, analysts remain sharply divided on the key question about the economy: How much further will the central bank allow interest rates to fall?

Many economists expect short-term interest rates to decline steadily for the rest of the year. They argue that the Fed will be able to ease credit further because inflation will moderate in response to the recent economic slowdown.

But other analysts contend that the Fed is unlikely to permit rates to drop much further. Prices, these analysts say, will continue rising at about their current rate unless the economy plunges into a recession.

One thing seems likely. Because Fed officials have no clearer crystal ball than anyone else, they appear likely to go slow in making adjustments in monetary policy.

“The Fed is going to be very cautious in the months ahead,” said Larry Kudlow, chief economist at the Bear, Stearns investment firm in New York. “The members of the Open Market Committee (the Fed unit that sets credit policy) are just as confused over the future direction of the economy as everyone else.”

During the past 15 months, the Fed had jacked up interest rates by engineering a series of credit-tightening moves. As a result, the federal funds rate, which banks charge each other for overnight loans, rose from about 6.5% in February of last year to 9.75% in mid-March of this year.

But this week, following two reports indicating that the economy had slowed further in May, the central bank allowed the federal funds rate to slide to about 9.5%. It closed at 9.44% Wednesday.

The Fed eased credit passively, by declining to drain reserves from the banking system. Its modest initial action will have little direct effect on the economy.

But it marks an important symbolic turning point for the Fed. It suggests that a majority of Fed officials believe that there will be no reason in the foreseeable future to drive rates back up.

“This indicates they think the period of tightening monetary policy is behind us,” said Lyle Gramley, chief economist at the Mortgage Bankers Assn. and a former Fed board member. “But they will be cautious in pushing rates down further because there is no guarantee that the inflation threat has abated.”

Monetary policy is set by the 12 members of the Open Market Committee, which includes all seven Washington board members and a rotating five-member panel chosen from among the presidents of the 12 regional Federal Reserve Banks.

The panel reflects at least three fundamentally different viewpoints on what causes inflation. A few members pay closest attention to the money supply. Others, including Fed Chairman Alan Greenspan, are most interested in indicators of real economic activity such as job creation and production bottlenecks. A third camp closely follows market indicators such as commodity prices and the value of the dollar.

It was only recently that all of the various indicators began pointing in the same direction.

“Friday’s employment report was the last straw,” said Alan Reynolds, a leading supply-side economist at Polyconomics Inc., a research firm in Morristown, N.J. The report showed the slowest job growth in three years.

“For supply-siders, the climbing dollar and collapsing metals prices started signaling the need for Fed easing several weeks ago,” Reynolds said. “There are a few diehards left, but most of them threw in the towel over the weekend.”

Reynolds expects the interest rate on long-term 30-year Treasury bonds, which hit a peak of 9.33% in late March but was at roughly 8.4% this week, to continue to fall well under 8%. He thinks the threat of inflation has been overstated by most economists.

“The necessity for further tightening has passed,” Reynolds said, “and the Fed can now reap the reward of restored confidence in the dollar by letting nominal interest rates decline.”

But other analysts contend that the underlying inflation rate, which does not include shocks from jumps in food and energy prices, is likely to continue creeping upward because of tight labor markets and limits on expanding industrial capacity.

“Just because the economy is growing more slowly doesn’t mean that inflation is going to melt away,” said David Hale, chief economist at Kemper Financial Services in Chicago.

The economy’s recent performance has led many analysts to believe that it is coming in for an unprecedented “soft landing” in which tighter monetary policy helps cool off inflation without plunging the economy into a recession.

“Pulling off a soft landing is like landing a B-1 bomber on an aircraft carrier,” said Charles Renfro, chief economist at Alphametrics Inc., a Philadelphia-based forecasting firm. “Nobody has ever done it before, but that doesn’t mean it’s impossible.”