Weekly Commentary by Dr. Scott Brown
The Federal Reserve Outlook
November 2 – 6, 2009
The advance estimate of third quarter GDP growth provided conclusive evidence that the recession is over. However, the recovery is still expected to be gradual,
fragile, and insufficient in the near term to generate much improvement in labor market conditions. Fiscal policy will provide further support into the early part of
2010, but will turn lower later next year, effectively acting as a drag on overall GDP growth. Hopefully, the private sector will be strengthening enough at that time
to offset the drop-off in fiscal stimulus. If not, a second smaller stimulus package may be needed. However, amid concerns about the federal budget deficit, the
political environment is likely to be resistant to the idea of further fiscal stimulus. That leaves the Fed to do the heavy lifting.
The Fed has a dual mandate, maximum sustainable growth and low inflation. However, over the long term, there is really only one goal. By keeping inflation low,
the Fed will generate optimal economic growth. Consumer price inflation has turned
negative over the last year, reflecting the unwinding of last year’s energy price
increases. Measures of core inflation, have drifted lower. The Fed has long had an
implicit inflation target of 1% to 2%. However, a few Fed officials have indicated that a
2% to 2.5% range may be more appropriate, giving the Fed more room to cut rates in a
weak economy.
Of course, the Fed isn’t worried about past inflation. The focus is on keeping future
inflation low. While inflation is a monetary phenomenon, it appears through pressures in
resource markets. With unemployment near 10% – and expected to remain there for
some time – wage pressures are not going to be an issue. The Employment Cost Index
rose just 1.5% in the 12 months ending in September, and productivity growth appears
to have remained very strong. Capacity utilization remains low. So, you’re not going to
see inflation pressures due to production constraints.
Commodity prices are a different story. A strong global growth outlook (over the next
10 to 20 years) should generally lead commodity prices higher. However, it takes a huge
increase in commodity prices to have much of an impact at the consumer level. Oil is a
special case, being pervasive through the economic system, and its price (relatively
steady now) remains a major wildcard in the economic outlook.
In addition to pressures in resource markets, the Fed also considers inflation expectations in its inflation outlook. The price of gold has risen in recent weeks, but
gold is not the inflation hedge it once was. The spread between inflation-adjusted and fixed-rate Treasury securities suggests that the market does not expect
inflation to be a problem over the next several years. Should inflation expectations begin to rise, the Fed would likely tighten sooner, all else equal.

There has been growing speculation that the Federal Open Market Committee may alter
the wording of its policy statement on Wednesday. The Fed will not signal that short-term
interest rates are headed higher anytime soon, but it may jettison the phrase that
“economic conditions are likely to warrant exceptionally low levels of the federal funds
rate for an extended period,” replacing it with something similar, but sounding less like a
commitment. One alternative would be to spell out the conditions that would lead to a Fed
rate hike.
Looking ahead, the Fed seems unlikely to raise short-term interest rates until the second
half of next year, but it depends. If bank lending begins to improve and the economy
appears on more solid footing, then taking the foot off the accelerator floor would be an
appropriate response.
However, the fiscal stimulus will fade in the second half of next year and into 2011. The
Bush tax cuts sunset at the end of next year. With fiscal policy working in the wrong
direction, Fed policy will be responsible for keeping the recovery going.
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