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January 10, 2007 7:11 pm

The Federal Reserve scales tip towards cuts

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Central banking can be a bit like dentistry. You need great technical skill, an understanding of the latest research and years of experience, but all are for nought without the trust and confidence of the subject you are operating on. The US Federal Reserve are masters of reassurance: Don Kohn, vice-chairman, used a speech this week to argue that growth will pick up later in 2007. But such words should not be mistaken for a reluctance to cut interest rates.

During the second half of last year, with headline inflation driven above 5 per cent by fuel and housing costs, the data suggested aggressive rate rises by the Fed. But the central bank stuck to measured quarter-point rate rises, and stopped earlier than many expected in June last year, with a Fed funds rate of 5.25 per cent.

That stance now looks to have been correct: inflation has fallen whether volatile items such as food and fuel are included or not. Lower oil prices have been the biggest influence, both directly, via fuel costs, and in cutting the price of things such as transport. That has prompted Mr Kohn to worry that the fall in inflation may be temporary.

But the impact of a slowing housing market has yet to fully show up in prices. New housing starts are far below the levels of last year, and are also below the level of completions, which means that activity will continue to fall for some time to come. Housing is the biggest component of the consumer price index and should hold it down later in the year.

Lower inflation, alongside a slower economy, would normally mean lower interest rates. But a strong employment market could stay the Fed’s hand. Only 4.5 per cent of the workforce is out of a job and many specific labour markets are much tighter: less than 2 per cent of university graduates, for example, are out of work.

Rising wages could push up inflation unless immigration, or increased participation in the labour market, hold them back. But looking forward a year or two, with growth on its current, mediocre trajectory, a small output gap is likely to open up. In that context, even a tight labour market is unlikely to suffer runaway wage growth.

Monetary policy is reasonably tight at present, with long-term rates 50 basis points above those on overnight deposits, and Mr Bernanke has begun to build an inflation-fighting reputation. The Fed, therefore, has scope to cut rates, even if downside risks – such as a sharp rise in saving because of slower house price growth – do not emerge.

There is no pressing need to act: despite the weakness in housing and in consumer spending over the holiday season, the economy is in reasonably good shape. The Fed will repeat that message to encourage confidence and economic activity. But some intervention seems likely as well, perhaps a statement that the Fed is minded to ease, followed by a couple of quarter-point rate cuts before the autumn.

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