Easing inflationary expectations and growth concerns have elbowed the Fed into a more neutral policy stance. But, as financial markets seem to do, it may be premature to expect further policy easing from the Fed. By Vivek Sharma

As the US Fed officials, led by chairman Ben Bernanke, assembled earlier this week to decide the interest rate policy, there was hardly any doubt in the markets that they will leave the Fed rate unchanged at 2 per cent. The markets were more interested in the tone of the policy document, to assess what the Fed's future course would be. Though fears of an inflation spiral in the coming months have subsided, fears of the credit crisis worsening have surfaced in recent weeks. That made the policy environment more uncertain than when the Fed met last in June.

In the end, the financial markets got what they wanted. The Fed chose to hedge its bets and preferred a neutral language, strengthening the possibility that rates will remain on hold for the rest of the year. There was no indication in the policy statement as to which way the Fed is leaning, to support growth or to fight inflation. While the Fed is hopeful that 'the substantial easing of monetary policy combined with ongoing measures to foster market liquidity should help to promote moderate economic growth', it maintained that 'financial markets remain under considerable stress' and the 'ongoing housing contraction' and 'elevated energy prices' may affect growth in coming quarters. The statement had hardly any clues about the relative weights or significance of any of these factors.

Inflationary pressures ease
Early last month, crude oil appeared all set to cross $150 per barrel and rise even further. Just as politicians the world over blamed speculators and regulators sought to curb speculation, prices corrected on signs of physical demand adjusting to higher energy costs. From a high of over $145 per barrel, crude oil has now corrected more than 20 per cent and some say the commodity has now entered a short-term bear market. Not surprisingly, nobody is blaming speculators for the price decline.

It is not just crude oil, but prices of most commodities have slipped over the last month. Even food prices, a major concern of policy makers until recently, have moderated. In countries like India where fuel and food are subsidised, decline in their international prices do not bring any immediate relief as retail prices are set even lower. But in countries like the US, consumer prices adjust lower immediately and inflationary expectations ease.

Lower commodity prices were a major relief for the Fed, ahead of the policy meeting. Else, the Fed would have been forced to take a more hawkish stance. The inflation rhetoric has been toned down in the policy statement and the language is suggestive of the Fed expecting inflationary pressures to ease further in the coming months. In a way, lower commodity prices have done part of the job for the Fed which was bracing itself to refocus on fighting inflation.

Though the Fed statement clearly states that 'labour markets have softened further', it is widely believed that many members of the Fed's policy setting committee are concerned about a wage-price spiral. The fear is that with consumer inflation above 5 per cent, workers will demand higher wages. That sounds perfectly logical and it is also true that labour unions, or Big Labour as they call them, hold considerable sway in the US. But, when the economy is weak and unemployment is rising, even the powerful labour unions will find it difficult to force employers accept pay hikes.

But growth risks resurface
On the face of it, US economic data continues to better expectations. The economy actually expanded 1.9 per cent in the April – June quarter, an exceptionally strong performance considering the fact that most forecasters expected a contraction until recently. Though the growth rates of previous quarters have been revised downwards, it now turns out that the US economy actually declined during the last quarter of 2007, the overall picture is one of considerable resilience in the face of very adverse odds.

The factors which contributed to the second quarter growth are a sharp improvement in external trade balance and continued growth in consumer spending. Real exports surged 9.2 per cent, as American companies continue to benefit from the weak dollar and demand growth in other parts of the world. At the same time, American consumers are reacting to higher import prices and real imports were down 6.6 per cent. Growth in consumer spending accelerated to 1.5 per cent from 0.9 per cent in the first quarter. If not for the inventory drawdown, overall GDP growth for the quarter would have been much higher.

But, the Fed is more worried about growth than it was earlier. In its last policy statement in June, the Fed said 'downside risks to growth have diminished somewhat'. In the latest statement, such hopes have been toned down with 'downside risks to growth remain'.

At the previous meeting, the Fed was justifiably confident that its aggressive rate cutting and liquidity infusion have stemmed the crisis in credit markets. The markets seemed to have stabilized and economic data was positive. But subsequently, things have turned for the worse.

First was the bailout of a regional bank from the brink of collapse. That event opened up the risks of more bank failures, something more analysts are now willing to factor in. The more pessimistic now expect many smaller banks to fail, eventually leading to large scale consolidation in the industry. With the credit market remaining weak, opportunities to make money from securitization and financial derivatives have dwindled. Banks are now being forced back to their traditional lines of business, which is also under strain because of the economic slowdown.

But the consolidation in the sector will be a long drawn out process as the big players are also struggling. On top of the astronomical losses they have booked in recent quarters, to avoid litigation, big banks are now being forced to buyback some of the securities they sold earlier. All these require additional capital, something that may become increasingly difficult to come by.

Then there is the continuing slump in the US housing market. True, latest data indicates that the market may be nearing a bottom. The rate of decrease in home prices has slowed down and there are some signs of demand picking up, very slowly. But, the troubles at Freddie Mac and Fannie Mae and the possible decline in income growth can worsen the crisis.

Freddie Mac and Fannie Mae dominate the home mortgage refinance market in the US. Both firms are now in deep trouble and in urgent need of large capital infusion. When the re-financiers struggle for capital, credit flow to the housing market will obviously take a hit. That will stop any possible housing market recovery in its tracks, which explains the urgency shown by the US treasury and the Fed to back Fannie and Freddie. Many analysts now expect these two institutions to be eventually taken over by the US treasury.

If that was not enough, recent data indicate that mortgage delinquencies are rising sharply among the prime borrowers. Slower income growth, dwindling bonuses and rising living expenses have upset the budgets of most Americans and more are struggling to make the monthly home loan payment. Credit card defaults have been rising steadily over the last many months. These can trigger another wave of write downs in securities linked to these assets. Add mortgage backed securities originated in Europe, where home prices are falling, it becomes clear that it is too early to call an end to the global credit crisis. Obviously, the Fed is worried.

Will the next Fed move be a rate cut?
Until last month, almost all analysts and forecasters agreed on one or more rate hikes by the Fed before the year end. They are not sure anymore, and in fact some are now predicting a rate cut as the growth outlook may worsen. They believe, because of the factors explained earlier, the credit crisis will see another flare up in the coming months and the Fed may cut rates by up to 50 basis points to 1.5 per cent. That will be the lowest since Greenspan cut the Fed rate to 1 per cent, in a series of moves after 9/11.

Financial markets are factoring in this possibility of a rate cut while fears of a rate hike have eased, going by the more than 300 points rally on the Dow Jones index on the day the Fed announced its decision. It is quite possible that the Fed will hold steady for the rest of the year. But, it may be a bit premature to expect a rate cut unless the credit markets slip back into turmoil with the same viciousness as earlier. If that happens, rate cuts will be hardly of any relief.