Fed Pleased with Slowdown,
Leaves Rates Unchanged

The Federal Reserve Board left interest rates unchanged at its October Open Market Committee meeting, saying that "the expansion of aggregate demand has moderated to a pace closer. . . to the economy's potential." The official statement indicated that the committee still believes "risks to the economy are weighted mainly toward heightened inflation." Supporting an assessment that growth was slowing, the Index of Leading Economic Indicators (designed to predict economic conditions in the next 6 months) fell 0.1% in August, after dropping 0.2% in July. The Index has been flat or declining for all of 2000 except for a 0.1% increase in March.

Oil prices remain a wild card that could push monetary policy either way, especially given the tight labor market and strong demand. On the one hand, they create an inflationary ripple effect throughout an economy already bumping against capacity constraints. The consumer price index in August was 2.6% higher than a year earlier, excluding energy prices, as compared to a 2.1% for all of 1999.

However, higher oil prices also impose a drain on household budgets, through higher gasoline and energy prices. This dampens spending and serves as a brake on overall growth, which is exactly what the Fed has been trying to achieve with its series of rate hikes beginning in mid 1999 (taking the Federal funds rate from 4.75% to 6.5%, by May, 2000). Although the economy expanded at a surprising 5.3% annual pace in the 2nd quarter, most analysts expect the pace to drop to between 3 and 3.5% for the rest of 2000. "The days of 5% GDP growth are behind us," said Ken Goldstein, an economist at the Conference Board (WSJ, 10/4/00).

Indeed, just over half of the members of the professional forecasting panel that comprise the Blue Chip Economic Indicators believe the Fed is finished tightening for the foreseeable future. That does not mean a rate cut is imminent: demand conditions remain strong and the labor market is tight, so there appears to be no need for a more accommodating monetary policy. In fact, mortgage rates declined during the summer and triggered some resurgence in the housing market, although new-home sales remained about 2.3% below the torrid pace set in 1999. The average national rate on 30-year, fixed rate mortgages was 7.88% during the last week of September, well below the 8.64% average back in May. Still, the combined impact of higher energy prices and the lagged impact of the series of Fed rate hikes over the past year continue to dampen spending and growth, achieving the "soft landing" to a sustainable, non-inflationary growth path that has been the Fed's objective. The consensus panel estimate of the odds for a U.S. recession within the next 12 months or 24 months are 16%, and 29%, respectively. Both are the lowest odds since last spring.