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Washington Budget Chaos Keeps Fed Interest Rates Low for Longer

Thursday, 10 October 2013 07:01 AM

Three years from now, Federal Reserve forecasters expect the economy will still be struggling to overcome one of the biggest obstacles to growth: U.S. fiscal policy.

Most Fed officials last month predicted drag from fiscal restraint, a slow recovery in housing markets, and tight credit would cause them to hold the benchmark lending rate at 2 percent or lower until the end of 2016 to support growth and job creation.

“It is harder to get to full employment when you are in fiscal chaos,” said Allen Sinai, chief executive officer at Decision Economics Inc. in New York. “They have to be easier longer. It makes them look like they are slaves to fiscal craziness.”

Policy makers’ interest-rate forecasts showed they were building long-term fiscal dysfunction into their outlook even before the partial federal government shutdown and impasse over raising the debt ceiling. Now, the wrangling in Washington is also pushing back the timeline for a reduction in bond purchases that would precede any increase in interest rates.

The shutdown has interrupted the flow of government data the Fed uses to evaluate the health of the economy, from factory orders to trade and unemployment. It also threatens to curtail economic growth after as many as 800,000 government workers were furloughed.

Data Dependency

“The Fed is not going to taper while the government is shut down,” said Dean Maki, chief U.S. economist at Barclays Plc in New York. “One, there is a weight on the economy and, two, the Fed calls itself ‘data dependent’ and it’s hard to be data dependent when there’s no data coming out.”

Maki, a former Fed board economist, said the fiscal impasse means a decision to taper bond purchases when central bankers’ next meet Oct. 29-30 is “quite unlikely.” He predicts a reduction in the pace of bond buying in December, though he said “the fiscal uncertainty has put that at risk.”

Keeping the Fed’s $85 billion in monthly bond purchases in place protects the economy from the effects of the shutdown, according to Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis.

“Our accommodative policy is a useful buffer against these kinds of fiscal disturbances,” Kocherlakota, who votes on policy next year, said in an interview last week.

Policy Wisdom

Atlanta Fed President Dennis Lockhart said on Oct. 3 the central bank’s surprise decision last month to maintain the pace of bond purchases was “wise” given the subsequent shutdown.

“We avoided a potentially very awkward situation of reducing stimulus just on the eve of what now has developed,” Lockhart told reporters at a conference in Atlanta.

Treasurys fell and rates surged on bills maturing on the Oct. 17 deadline projected for when the U.S. reaches its borrowing capacity.

Rates on Treasury bills due on Oct. 17 climbed 20 basis points, or 0.20 percentage point, to 0.478 percent at 5 p.m. New York time, according to Bloomberg Bond Trader prices. Rates were negative as recently as Sept. 26.

U.S. stocks rose amid optimism that Janet Yellen, President Barack Obama’s nominee to succeed Ben S. Bernanke as Fed chairman, won’t rush to withdraw stimulus. The Standard & Poor’s 500 Index gained 0.1 percent, after plunging 2.1 percent over the previous two sessions.

Tapering Likely

Most policy makers said the central bank was likely to reduce the pace of its bond purchases this year and end them in mid-2014, according to minutes of their last meeting released Thursday. Officials have said they will maintain the quantitative easing program until the labor market has “improved substantially.”

Policy makers at the meeting cited “a number of significant risks” to the outlook, including “those related to the potential economic effects of the sizable increases in interest rates since the spring, ongoing fiscal drag, and the possible fallout from near-term fiscal debates.”

The partial shutdown is the latest chapter in a series of budget battles that started in 2011 with a showdown over the debt ceiling and led to the first-ever reduction in the nation’s top credit rating. The conflict continued this year with across-the-board budget cuts, known as sequestration.

Spending Contracting

Federal spending has contracted in nine of the last 11 quarters on an annualized basis, subtracting from growth in each period. The U.S. economy has grown at a 2.2 percent annualized pace on average since the current expansion began in June 2009, compared with about 3 percent in the five years leading up to the recession, according to Commerce Department figures.

The U.S. budget deficit for fiscal 2013, which ended Sept. 30, is projected to be 3.9 percent of gross domestic product, down from 9.8 percent in 2009, the year Obama took office, according to data from the Congressional Budget Office.

Bernanke said at a press conference last month that the Fed is pushing against “substantial fiscal headwinds” that probably slowed 2013 growth by a full percentage point and reduced employment by “hundreds of thousands of jobs.”

The shutdown that started in Oct. 1 may compound the economic pain. If it lasts through the end of the week, the shutdown will probably cut 0.2 percentage point from the pace of economic growth this quarter, according to the median forecast of economists surveyed by Bloomberg.

Fiscal Drag

“The fiscal drag that’s been generated leads to easier Fed policy than would be the case otherwise,” Maki said. “The Fed is influenced by fiscal policy, whether or not individual members agree or disagree with that policy.”

Fiscal policy will remain a drag on growth for years to come, Fed forecasts show. Policy makers see the economy growing 2.5 percent to 3.3 percent in 2016 with the unemployment rate at 5.4 percent to 5.9 percent. Price increases would be near or at the Fed’s 2 percent goal.

Typically, under such conditions, the federal funds rate would be around 4 percent, Fed officials’ forecasts show. That’s the so-called “neutral rate” that balances saving and spending decisions by consumers and companies. Instead, most policy makers see the rate at 2 percent.

Dana Saporta, a director of U.S. economics research at Credit Suisse Groupe AG in New York, said the federal funds rate may not return to “neutral” in this decade.

“Fiscal policy is one of the reasons that that’s the case,” Saporta said.

Continuing Retrenchment

Fiscal retrenchment will continue as the government deals with spiraling costs of healthcare and Social Security. That will figure in hiring and investment decisions by companies, according to Tim Duy, a professor at the University of Oregon in Eugene and a former U.S. Treasury economist.

“What is causing uncertainty is that we have fallen off the trend of long-run GDP growth,” he said. “Now you have uncertainty about what the path of economic policy is.”

Richard Dreiling, chairman and chief executive of Dollar General Corp., a Goodlettsville, Tennessee-based discount retailer, said last month that its typical customer “has never come out of the recession,” and fiscal policy is dealing another blow to incomes after an increase in payroll taxes that took effect in January.

“The average consumer out there who makes $50,000 a year has $1,000 a year and less in spendable income now due to the changes that have taken place in the payroll tax,” he said on a Sept. 4 conference call with analysts.

“The drag on the economy is largely based on fiscal policy mismanagement,” said Marvin Goodfriend, a former Richmond Fed policy adviser who is now a professor at Carnegie Mellon University in Pittsburgh. “I don’t think anybody would have imagined that central banks would have been put upon to such extent by such an irresponsible fiscal policy.”

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Three years from now, Federal Reserve forecasters expect the economy will still be struggling to overcome one of the biggest obstacles to growth: U.S. fiscal policy. Most Fed officials last month predicted drag from fiscal restraint, a slow recovery in housing markets, and...
Thursday, 10 October 2013 07:01 AM
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