Is the Economy Really Healthy Enough to Tighten Monetary Policy?

Source: alisonbowden14 / Flickr

Source: alisonbowden14 / Flickr Creative Commons

In mid-December, a majority of FOMC members voted that the first increase in the federal funds rate — the benchmark overnight borrowing rate between banks — would not be warranted until 2015. The Fed has signaled that it will stick to an accommodative policy as long as the unemployment situation is tenuous and inflation remains below the targeted 2 percent.

As a part of its accommodative policy, the Fed has been purchasing $20 billion worth of mortgage-backed securities and $25 billion worth of longer-term Treasuries on a monthly basis under a program called quantitative easing. These purchases put downward pressure on longer-term interest rates, which spurs business activity and spending in sectors like housing, but the Fed has been cutting combined purchases by $10 billion each month since December 2013 as economic conditions improve.

Monetary policy works slowly, but the impact that quantitative easing is having on the economy is finally beginning to reflect on the barometers. For example, jobless claims hit a seven-year low in May, according to data provided by the Labor Department. Initial claims for state unemployment benefits fell by 24,000 to a seasonally adjusted level of 297,000 in May, the lowest reading since May 2007.

Even the overall unemployment rate for May stands at 6.3 percent. The Fed has maintained it will keep the federal funds rate at the zero bound until well after it has exited its asset purchase program next year. The Fed will keep interest rates untouched until labor markets have shown sustainable signs of recovery, especially if inflation falls below its goal of 2 percent.

But consumer prices, as measured by the Consumer Price Index (CPI), rose 0.4 percent on the month in May and were led by an increase in food and gasoline prices. Year-on-year consumer prices increased 2.1 percent, the highest growth since June.

Although the indicators show improvement, worries about slow economic growth still plague the Fed. Real gross domestic product growth — the increase in the total value of all goods and services produced in the country — was revised from an initial estimate of 0.1 percent to negative 1 percent in the first quarter.

The International Monetary Fund also cut its full-year U.S. GDP growth forecast to 2 percent due to the weak first quarter, a global slump in demand, and weakness in the housing sector. In its annual review of U.S economy, the IMF called for the Fed to provide liquidity support for longer than the current timeline of mid-2015.

The Fed expects GDP to grow in the range of 2.8 to 3.2 percent in 2014, but the Philadelphia Federal Reserve’s quarterly survey of 42 forecasters recently declined, showing full-year growth estimates falling back to 2.4 percent from the earlier estimate of 2.8 percent, also due to a wobbly first quarter.

According to the survey, analysts expect the economy to grow at 3.3 percent in the second quarter, an upward revision from 3 percent earlier. They also expect an accelerated pace of hiring in the current quarter. The average monthly non-farm job growth could be around 232,000, against the previous forecast of 193,500.

As the FOMC meets, Janet Yellen and her team may side with the IMF and find that the jobs outlook continues to support a dovish monetary policy. However, given the recent inflation data, hawkish members of the board of governors are likely to advocate for more rapid tightening.

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