Economist: Fed Could Cut Interest Rates By Fall

Following the May 9 decision of the U.S. Federal Reserve to leave interest rates unchanged, Euler Hermes ACI Chief Economist Daniel C. North issued the following commentary:

As expected yesterday, The Federal Reserve held the Fed Funds interest rate steady at 5.25%. In the statement accompanying the action, the Fed cited both economic growth and inflation as concerns. The statement noted that "Economic growth slowed in the first part of this year and the adjustment in the housing sector is ongoing" but it also stated that "Core inflation remains somewhat elevated … (and) the high level of resource utilization has the potential to sustain [inflationary pressures]."

Despite concerns over both factors, the Fed's bias towards fighting inflation remained unchanged, saying that the "predominant policy concern remains … inflation." The fact that several inflation indicators remain at "elevated" levels certainly contributes to this bias. Perhaps most importantly, the Personal Consumption Expenditures (PCE) core rate still remains above 2%, which is thought to be about the Fed's highest tolerable rate on its most carefully watched gauge.

But inflation concerns may be abating. The Fed must certainly have been happy to see the most recent reading of the PCE core was 2.1% in March, as opposed to the 2.4% rate it displayed in February. In addition, critical Unit Labor Costs, which measure wages after taking into account productivity, fell to a 1.3% year over year growth rate in the first quarter of 2007 versus 3.4% in the fourth quarter of 2006. Since inflation in labor costs is more influential than in materials costs, this was welcome news indeed.

Furthermore, the Fed's reliance on a slowing economy to "moderate" inflationary pressures seems to be coming to fruition. First quarter GDP growth was an anemic 1.3%, the slowest in four years. The latest employment report showed only 88,000 jobs created in April, the lowest in two and one half years. The second lowest during that period was just in February at 90,000 jobs. The unprecedented demise of the housing market no doubt is helping curb the consumer; April same-store sales at major retailers fell well below expectations. The Treasury yield curve is still inverted and has been since last July, a historically strong indicator of a slowing economy. Given the weakness in the economy, the Fed may only have to wait until the fall to shift its bias towards growth and start cutting rates."