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The Federal
Reserve announced at the end of its October 24-25 policy meeting that it
would keep the Federal Funds rate at 5.25 percent. However, Bernanke and
his colleagues indicated that they were still concerned with the September
core inflation rate of 2.9 percent. The core inflation number excludes the
volatile energy and food sectors of the economy. The overall consumer price
index rose by a more modest 2.1 percent in September.
The Federal
Reserve observed that, although it was not comfortable with the core rate of
inflation, the consensus opinion was that lower energy prices, lower housing
prices, and a general decline in economic activity would filter its way
through the economy. They feel these factors will place downward pressure
on the core component of the consumer price index. The Federal Reserve’s
position is that price stability is absolutely essential for the long run
health of the economy.
The Federal
Reserve, as everyone knows, has been tightening credit conditions for
several years in an attempt to keep inflation under control. The short run
tradeoff has been slowing of the economy. The latest GDP estimate is that,
in the third quarter of 2006, the economy expanded by only a 1.6 percent
annualized rate. This is the slowest rate in about three years. Clearly
the campaign to raise short term interest rates and to lower the growth rate
of the money supply has had a negative impact on the amount of goods and
services produced. As recently as 2003, the M2 measure of the money supply
was growing at over 8 percent. In September 2006, this rate of expansion
dropped nearly in half to 4.4 percent.
In addition
to weak GDP numbers, there are other indications that the economy is
slowing. The index of leading economic indicators has been trending lower
since the beginning of 2006. The Institute for Supply Management’s
composite index has also been trending lower since early 2006. This is a
measure of the business sector’s expenditures on goods and services. In
addition, the nonfarm payroll employment growth rate has been flat since the
start of 2006, growing at an annualized rate of 1.3 percent.
Probably
the sector of the economy which has experienced the most difficulty in 2006
has been the housing sector. The Wall Street Journal (WSJ) reports that the
median price of existing homes fell by over 2 percent in September. This is
the largest decline in nearly 40 years of record keeping. This is the first
back to back monthly decline in median housing prices since 1995. Other
indicators of the slump in housing are the number of existing family home
sales and single family housing starts. Specifically, existing home sales
were running at over 6.2 million units in 2005, and by August 2006 the
annualized rate was 5.5 million. Likewise, single family housing starts
were running at a 1.8 million pace throughout most of 2005, and by September
2006 the rate declined to 1.4 million units.
Let’s hope
the Federal Reserve, in its exuberance to battle inflation, does not push
interest rates so high or curtails the amount of liquidity so much that it
drives the economy into a recession. However, if the Federal Reserve can
engineer a soft landing for the economy it would create an economic
environment that is conducive to a long term expansion in income, output,
and employment. Only time will tell which one of these scenarios comes
true. |
