Fed Shifting to Neutral or Keeping ‘Inflation Bias’?

Amid a slowing economy, analysts are almost unanimous that Federal Reserve officials will leave short-term interest rates unchanged when they meet on Wednesday.

But Fed watchers are divided over whether Fed Chairman Alan Greenspan and his colleagues on the Federal Open Market Committee will conclude once again that the risk of higher inflation in the future is greater than the risk of a much deeper economic slowdown.

Many analysts predict that the Fed will keep that so-called inflation bias in the statement it issues after it meets. However, some others believe economic growth has slowed enough that the Fed may be ready to drop that bias in favor of a “neutral” statement.

The issue is important because a shift to neutral probably would be taken by financial markets as a signal that a Fed rate cut could follow sooner than later.

The standard language for the bias statement is, “Against the background of its long-term goals of price stability and sustainable economic growth and of the information currently available, the [Fed] believes the risks continue to be weighted mainly toward conditions that may generate heightened inflation pressures.”

“The big question is the bias,” said Bill Dudley, economist at Goldman, Sachs & Co. in New York. “I think they will keep it in place for a couple of reasons.

“First, with an unemployment rate of 3.9%, labor markets are still tight and there are some more signs of rising wage pressures. Second, inflation has been creeping up. And third, keeping the bias is the path of least resistance.

“Besides, if they dropped the bias it could provoke a big rally in the stock and bond markets, and that’s not what the Fed wants to see” because of concerns that rising share prices could fuel consumer spending and inflation, Dudley argues.

Based on futures contracts on the Fed’s target “federal funds” rate--the rate banks charge each other on overnight loans--some traders already are betting the Fed will cut rates in the first half of 2001. That would be the first rate cut since late-1998.

The March futures contract suggests investors believe there is a 50-50 chance the Fed will lower its target for fed funds from the current 6.5% to 6.25%, sometime in the first three months of 2001, said economist Stephen Slifer at Lehman Bros. in New York.

But Slifer, for one, doubts it will happen. “Simply put, we think that the economy is growing too quickly and that the labor markets are too tight for that to occur,” he said.

After growing at a 5.2% annual rate in the first half of this year, the U.S. economy took a bit of a breather in the July-September period, when growth slipped to a 2.7% rate. However, a number of unusual factors may have exaggerated that slowing, such as a drop in federal purchases of goods and services.

Many forecasters expect growth to be up again in the current quarter, most likely to a 3.5% to 4% pace.