What Does the Economy Look Like to the Federal Reserve?

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The only real difference between the two Federal Open Market Committee (FOMC) statements released in April and June is this: The Fed appears to be more worried about inflation staying lower than 2 percent now than it was six weeks ago. Other than that, Fed policymakers appear to continue to be happy but cautious about signs of economic revival after a cold first quarter.

Though the Fed struck a positive note in its most recent statement about the expected bounce back in the economy in the second quarter, it did revise its forecast for overall economic growth for full-year 2014 down from a range of 2.8 to 3 percent to a range of 2.1 to 2.3 percent. This revision could have been based on weak trade numbers, which signal a slower pace of recovery in business sentiment, and a sluggish first quarter, when gross domestic product contracted by 1 percent. The Fed also expects fiscal policy and widening budget deficits to be a drag on economic growth.

The FOMC made clear that it would continue with its “highly accommodative,” or low interest rate and easy money policy, until the economy reaches maximum employment and prices stabilize. According to the economic projections of the Federal Reserve Board members, 12 out of 13 members believed that monetary policy must start firming up and change gears by 2015. More specifically, 15 members voted to leave the target federal funds rate – the overnight borrowing rate for banks — between zero and 0.25 percent for the rest of 2014 and then increasing it to between 0.25 and 3 percent in 2015.

The Fed’s concern about inflation trailing its targeted 2 percent makes a case for keeping the fed funds rate near zero for some time to come, though the latest data on consumer prices paints a different picture. Generally, inflation and interest rates move in tandem. When inflation rises above a sustainable level, the central bank has to resort to raising the federal funds rate in order to reduce consumption.

“The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance,” the FOMC statement released on Wednesday said, “and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.”

But recent data show that consumer price inflation is back within the Fed’s territory of comfort. Not just that, but prices have risen steadily in the last three months. Consumer prices, as measured by the Consumer Price Index for urban consumers (CPI-U), rose 0.4 percent in May, the third straight increase, according to data released by U.S Bureau of Labor Statistics earlier this month. The all-items price index is up 2.1 percent from 12 months ago, marking the largest increase since October 2012.

The Fed remains positive on its outlook on labor market conditions, as well. It has revised downwards its unemployment rate forecast from a range between 6.1 and 6.3 percent to a range between 6 and 6.1 percent in its projections. Over the last several months, the unemployment rate improved considerably, from 7 percent in November 2013 to 6.7 percent in March and 6.3 percent in April and May. The number of job losers and people who have completed temporary jobs has also declined by 218,000 in May, according to data published by U.S. Bureau of Labor Statistics.

Though the Fed is winding down its asset purchases, it is still committed to keeping interest rates low and monetary policy accommodative. But one concern that critics of accommodative monetary policy have is this: Will keeping interest rates near zero fuel a rise in asset prices? And then, will the Fed have to play catch up and increase interest rates sharply, thereby further risking the economic recovery?

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