Financial Times Editorial - Fed should pause now to fight inflation later

Financial Times Editorial - Fed should pause now to fight inflation later
Copyright The Financial Times Limited 2006
Published: October 25 2006 03:00 | Last updated: October 25 2006 03:00



Few doubt that the Federal Reserve will keep US interest rates unchanged today. The question in the mind of every investor concerns US monetary policy as the economy enters 2007. Growth is expected to weaken and inflation to remain higher than tolerable, making this a testing time for the Fed. The US could afford a slight moderation in growth, but it should certainly not allow a take-off in inflation.

Upward pressures on inflation are now about more than just oil prices. Since early 2005, the Fed has been brushing aside headline inflation of above 3 per cent by focusing on other measures excluding energy. But now even core inflation is at a 10-year high: the latest reading showed prices growing by 2.9 per cent in September. Fed officials have made it clear that such levels of inflation are too high.

It looks like the much-feared spectre of second round effects could be making an entrance. Because of their lower tax wedge, the past year has seen petrol and energy prices increase much more in the US than in Europe. This, in turn, has resulted in demands for higher salaries. In fact, wage inflation has jumped to 4 per cent from 2.7 per cent only a year ago. In the same way that higher oil prices failed immediately to push up core inflation, cheaper petrol could at best take months to feed through. At worst, higher inflation expectations may require more aggressive policy reaction at a later date.

The Fed's fight on inflation has to be balanced against its support for a cooling economy. Output figures to be released this Friday are likely to show a continuation of the weak growth seen in the second quarter. The main culprit is a slowing housing market, hitherto the engine of a booming US economy but now the main risk to the outlook.

Opinions abound on the length and depth of the adjustment, but a consensus is emerging that a soft landing - while not a certainty - is possible. The experiences of Australia and the UK, where the peak in house prices was not followed by recession, provide some encouragement.

Moreover, a slight rotation of world growth away from the US would lower the probability of a disorderly unwinding of global imbalances. The alternative of persistently high inflation could increase the risk of a sudden bout of market volatility, as seen in May.

The Fed should pause today to await developments in activity and inflation. Beyond this, the market does not really have a feel for how the Fed will strike a balance in 2007. This is undesirable. Ben Bernanke, chairman, has not yet established his hawkish credentials, having missed the opportunity to do so in August when market views on the Fed decision were most evenly split. In explaining future interest rate decisions, Mr Bernanke could draw inspiration from Europe's central bankers and emphasise the need for vigilance. Higher inflation, not weaker growth, is the greater evil.