The May FOMC Meeting: Time for a Pause?

May 11, 2006 – The FOMC voted yesterday to raise its Fed funds target by 25 basis points to 5% (Chart 1). The FOMC has raised its Fed funds target by 25 basis points at each of its last sixteen regularly-scheduled policy meetings.

Chart 1. The nominal and real Fed funds target. January 1987 to date.

According to the FOMC's post-meeting policy statement, the FOMC majority continues to forecast a slowing in economic growth to a “more sustainable pace”. (It has been “quite strong so far this year”.) A “gradual cooling of the housing market” is expected to contribute to this slowing, along with “the lagged effects of increases in interest rates and energy prices”.

On the inflation front, conditions haven’t changed since the last FOMC meeting in March. Although the inflation indicators remain reasonably well behaved, FOMC members continue to worry that “possible increases in resource utilization, in combination with the elevated prices of energy and other commodities, have the potential to add to inflation pressures”.

As far as the outlook for U.S. monetary policy is concerned, “The Committee judges that some further policy firming may yet be needed to address inflation risks but emphasizes that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information.” (Changes from the last FOMC statement are highlighted in red.)

In the last FOMC statement, this sentence said “…some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance.”

The new wording hammers home the FOMC’s message that U.S. monetary policy has become more data dependent, now that the FOMC has completed its “program” to gradually restore the Fed funds target to a “neutral” range. As noted in the January FOMC minutes, this means that the FOMC can no longer predict its own future policy actions “with the previous degree of confidence”.

Thus, although it would be premature to rule out further increases in the target Fed funds rate, we can't count on another increase at the next FOMC meeting in June. That will depend “importantly” on the economic data.

Further, the FOMC will not necessarily continue to limit future increases in its target Fed funds rate to small 25 basis point increments. The size of any future increases will also be data driven.

Finally, the FOMC statement continues to focus more on the upside risks to inflation than on the downside risks to economic growth – suggesting that FOMC has retained its tightening “bias”. (Easing is not being considered, at present.)

However, as Fed Chairman Bernanke told Congress last month, even if they aren’t entirely comfortable with the economy’s inflation risks, FOMC members might “decide to take no action at one or more meetings in the interest of allowing more time to receive information relevant to the outlook”.

Bottom line: The FOMC wants to get off the current tightening treadmill and broaden its range of choices.

Suzanne Rizzo