Federal Reserve & Interest Rates

In a speech before the Economic Club of New York, Fed Chairman Ben Bernanke see continued growth for the economy into next year.  He admits though that growth is likely to be slow due to a number of factors.

My own view is that the recent pickup reflects more than purely temporary factors and that continued growth next year is likely. However, some important headwinds–in particular, constrained bank lending and a weak job market–likely will prevent the expansion from being as robust as we would hope. I’ll discuss each of these problem areas in a bit more detail and then end with some further comments on the outlook for the economy and for policy.

Many economists believe we could be entering a jobless recovery phase, as it could be quite some time before the job market begins to recover.  Some believe the unemployment rate could reach as high as 13% before job creation starts again.

With inflation concerns still minimal at this time, he states that low interest rates will likely be warranted for some time and while some critics have called for higher interest rates, it could be as much as a year or more before we see any significant rise in the federal funds rate.

With banks expecting more loan losses from a weak housing market, a number of institutions have been hoarding cash, which has constrained bank lending to a degree.  Weak consumer spending has also caused credit demand to be well below normal levels, although those who are seeking credit are finding a difficult time of it.

While the banking system hasn’t fully recovered, it has stabilized somewhat and now that banks have sufficient capital reserves, the Fed has begun to ramp down it’s liquidity programs.  Although it’s balance sheet activity has slowed of late, it would not be surprising if we were to see the Fed use this tool once again next year if inflation concerns remain muted.

Although the economy returned to positive territory last quarter, an uncertain labor market is likely to put a damper on consumer spending and the holiday shopping season ahead.  On Friday, the Labor Department issued it’s October job’s report, which showed higher than expected job losses once again.

The unemployment rate rose from 9.8 to 10.2 percent in October, and nonfarm payroll employment continued to decline (-190,000), the U.S. Bureau of Labor Statistics reported today. The largest job losses over the month were in construction, manufacturing, and retail trade.

Now that unemployment has broken into the mythical double digit territory and slightly faster than many economists were predicting, it may give the government pause as it discusses exit strategies and an end to monetary and fiscal easing.  The labor market could very well put a damper on economic recovery over the long run and it could spur more fiscal spending into the new year.

This year’s stimulus package, while it also included tax breaks to spur consumer spending was also designed to create about 3 million jobs over a period of three to four years.  Thus far, little more than half a million jobs have been created and it pales in comparison to the over seven million jobs lost since the recession started.

Although the labor market typically lags behind the economy, some economists are predicting it could be as much as a year if not more before job creation begins again and that the unemployment rate could reach as high as 13% by then.  Even after the labor market starts to recover it liable to be a long and slow process, where we could still be over the double digit mark, two or three years down the road.

The Federal Open Market Committee met this week and to no ones surprise left interest unchanged once again and issued a press release following their meeting.

In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

There have been call from some circles to raise interest rates recently, most notably from former Fed Chairman Alan Greenspan.  While GDP grew once again in the last quarter, signaling the end of the recession, numerous problems still lie ahead for the economy.

The banking system is still in a fragile state, with many financial institutions hoarding cash, still reluctant to lend to consumers whose demand for credit is also well below normal levels.  The housing market, while it has had increased activity as of late, has yet to recover and that could still be years away.

Consumer spending is also way down and many household have increased their savings rate, with an uncertain labor market for the foreseeable future.  The economy is just at the start of the recovery phase but much of the positive GDP growth from last quarter was mostly due to the fact of the increased fiscal spending the government has undertaken over the past year.

It may be as much a year, if not longer before the Fed raises interest rates once again or begins shrinking it’s balance sheet for that matter.  While the Fed has to be careful about timing it’s exist strategy, with the current state of the economy, monetary easing doesn’t appear warranted just yet.