Will New Data Slow Fed’s Plan for Rates?

Friday’s surprisingly weak report on jobs had Wall Street focusing on one job in particular: that of Federal Reserve Board Chairman Alan Greenspan.

Greenspan and fellow Fed governors must decide whether the apparent dive in payroll growth warrants slowing or abandoning the central bank’s policy of gradual interest-rate increases -- a policy that just began June 30, when the Fed raised its key short-term rate for the first time in four years.

Most analysts still think that the Fed, at its meeting Tuesday, will follow through with another quarter-percentage-point hike in the so-called federal funds rate. That would boost the rate to 1.5% from 1.25%.

However, the July employment report suddenly cast doubt on whether the Fed’s tightening campaign would continue through its meetings in September, November, December and into next year.

In the near term, many Fed watchers believe that the central bank is trapped by its own public statements in recent months. Greenspan and other Fed officials have pronounced the economy to be healthy and said they needed to lift rates to guard against a resurgence of inflation.

Greenspan has said that he wanted to move gradually to a “neutral” position, where the federal funds rate is no longer below the rate of inflation and isn’t stimulative to the economy. That would imply further rate hikes totaling at least two percentage points over the next two years, many analysts say.

But Greenspan’s dilemma is that if the July jobs report is real evidence of a flagging economy, and if $44-a-barrel oil is heralding a wave of more general price increases, the Fed could be forced to choose between snuffing out the recovery with higher rates or letting inflation -- a most unwelcome boarder -- back in the house.

David Resler, chief economist at Nomura Securities International in New York, said the monthly payroll number was notoriously volatile and subject to extensive revisions. “There’s enough ambiguity in these data to dismiss their significance,” he said.

Other reports in the last month -- on vehicle sales, consumer confidence and manufacturing activity, for example -- have pointed to an economy that seems to be slogging through after a brief period of weakness in May and June, he said.

So far, Resler said, there isn’t enough evidence to cause the Fed to reverse its course of gradual tightening.

Gary Schlossberg, senior economist at Wells Capital Management in San Francisco, agreed. “I think the Fed would want more evidence of slowing growth before they move to the sidelines,” he said.

Some economists have a much more dire view of the Fed’s situation.

Newport Beach money manager Peter D. Schiff of Euro Pacific Capital thinks the Fed already has set the scene for much higher inflation by keeping interest rates at generational lows for the last two years.

Schiff blames the Fed for pulling its punches after the technology-stock bubble of the late 1990s burst in 2000. The central bank should have kept rates high enough to have allowed a prolonged recession to flush out market speculation and get consumers paying down loans and thinking about saving rather than spending, Schiff said.

Instead, when the economy slipped, the Fed in 2001 launched one of its steepest rate-cutting campaigns ever, slashing the fed-funds rate from 6% to 1.75% in just over 11 months. It cut again in 2002 and 2003.

The result, Schiff believes, was an unsustainable boom in consumer spending and housing prices, boosting household debt to record levels. The economy’s excesses still have to be flushed out, he said, but the remedy will be all the more unpleasant because it was postponed.

Driven by oil prices and a weak dollar, rising inflation will push long-term bond yields higher over the next year regardless of Fed policy, Schiff said.

“Interest rates are going to go a lot higher, and consumer spending is going to fall off a cliff,” he said.

In a report Friday titled “Tightening Into a Slowdown,” Merrill Lynch & Co.’s economic team noted the oddity of the central bank “raising rates into a decelerating economy.” Most of the time, the Fed has only raised rates in periods of rapid growth.

Merrill Lynch echoed some of Schiff’s points, saying that heavy debt loads, a low savings rate and high energy prices would hamstring consumer spending.

But Merrill forecasts only a cyclical economic slowdown ahead, not a recession. Merrill is much less pessimistic than Schiff about inflation and so believes that the Fed won’t have to tighten credit much to reach a “neutral” point with its key rate.

Even if the Fed was worried that the economy was slowing sharply, it would have to be careful about the message it sends, said Purdue University economics professor Gerald L. Lynch. “The Fed has the problem in that their actions -- especially over the last 20 years -- become self-fulfilling prophesies,” he said.

Investors and businesspeople believe that the Fed must have more, and better, information about the economy than they do. So any sign of hesitation in lifting rates could raise doubts about the economy among business owners, causing them to postpone hiring and slow the buildup of inventories, Lynch said.

Then, too, investors might continue to dump their stocks, pushing the market even lower and eliminating the “wealth effect” that has helped boost consumer confidence and spending over the last year, analysts say.

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Times staff writer Kathy M. Kristof in Los Angeles contributed to this report.