If Ben Bernanke and his cohorts on the Federal Open Market Committee (FOMC) were seriously thinking about raising rates on Wednesday, they’d have telegraphed it by now. A surprise rate hike could torpedo fragile credit and stock markets and undermine already feeble economic growth.
But hints of what the Fed might do next will matter. The key will be the balance FOMC strikes between boosting economic activity and fighting alarming-looking signs of inflation.
Credit worries: The US Federal Reserve in Washington, DC
Housing woes and high commodity costs are weighing on a fragile economy. In hindsight, ultra-low rates amplified the housing and credit boom and the following bust. But given where things now stand, the Fed might decide to help consumers and their employers by holding short-term interest rates steady at the current low 2%, or even cutting them further.
However, US inflation is running at an uncomfortable 4.2% annual rate, stoked by energy and food prices. Assuming the Fed wants to tackle price increases, that would suggest a bias towards a rate hike at the next FOMC meeting in early August.
That’s a tricky enough balance. But the Fed has also got itself heavily involved in financial markets. The US central bank also needs to consider how to keep money flowing around the financial system while avoiding the impression that it will rush to bail out irresponsible financial institutions—the “moral hazard” problem.
In some ways, financiers are in the same boat as the dying breed of housing flippers—they’d benefit from lower short-term interest rates. But the Fed has other tools it can bring to bear on Wall Street. Bernanke’s crew could make life a bit tougher for financial firms by raising the discount rate at which they borrow, or by signalling clearly that temporary measures—such as letting investment banks borrow from the Fed—won’t be extended.
Or if the Fed talks tough on inflation, as it should, it might try to keep the financial system primed by going easier on the discount rate, or by signalling that temporary liquidity measures will continue for a time. The risk is that the Fed goes too soft on inflation and financial markets at the same time. That could be a dangerous course with consequences that prove hard to reverse.