Kamp's Comments - Fed pauses, for now

by Leo Kamp, Managing Director and Chief Investment Economist, TIAA-CREF

The Federal Reserve's Federal Open Market Committee (FOMC) decided yesterday to leave its target for the federal funds rate unchanged at 5.25%. This is the rate U.S. banks charge one another for overnight loans. The Fed also stated that future rate moves would depend on upcoming data on economic growth and inflation. The vote, however, was not unanimous; Jeffrey M. Lacker, the President of the Federal Reserve Bank of Richmond, dissented. The Fed's statement said that he would have preferred an additional quarter-point hike now. Such dissents on the FOMC have been rare.

Yesterday's announcement by the Fed had been expected by many market participants--although I considered it an open question--ever since Fed Chairman Bernanke's Congressional testimony last month. As a result of these expectations, Treasury bonds have generally rallied since the chairman's appearance on Capitol Hill.

The Fed's press release, like the one issued after its last meeting and like Bernanke's Congressional testimony, indicates the Fed's inclination to avoid "overdoing" the tightening cycle. Rather than making low inflation its primary, or even exclusive, goal (as other central banks do), the Fed now is apparently giving economic growth much more emphasis. Yesterday's statement hinted at how the current slowdown in growth, together with the monetary restraint already in place, will help to contain inflation, which the Fed admits has been uncomfortably high recently, based on the "core" reading, which excludes food and energy prices.

The Fed directors seem to be looking for reasons why they should not raise rates higher and slow the economy further, despite "core" inflation moving up. However, I believe that the slowdown now in place (with real GDP growth currently running at an annual rate of 2.5%-3%) is unlikely to reduce inflation much, given that growth is running just slightly below the potential growth rate. This means that rising "core" inflation remains a substantial risk (especially with labor costs climbing more briskly and commodity prices higher)--a risk that will likely have to be dealt with by the Fed in the not-too-distant future.