What the Economists Say

ROBERT LIND, ABN-Amro global head of economics and equity strategy
Is the Fed losing its touch? Over the past few weeks, I've noticed growing criticism of the Fed's recent performance. After 18 years as Fed chairman, markets idolised Alan Greenspan. Now they're having difficulty coming to terms with Ben Bernanke's more open approach to expressing his opinion. This was inevitable. Markets forget that even Mr Greenspan had a troubled time in his early years (the 1987 stockmarket crash). And I suspect even Mr Greenspan would admit he was lucky to leave his job just as it got more difficult. The economy is close to a turning point and interest rates are around “neutral”. Perhaps markets will have to get used to more uncertainty.

Last night's Fed statement was another expression of this growing uncertainty. While the 25 basis point hike in the Fed funds rate was a foregone conclusion, the Fed is trying to keep its options open for coming months. The statement acknowledged the evidence of slowing economic growth and reiterated the Fed's view the economy would slow further. Yet the Fed doesn't appear unduly concerned about the severity of the slowdown. It believes there are balanced risks to the growth outlook. While the housing market is the most obvious downside risk, the Fed also believes there are upside risks. The corporate sector is in a strong financial position and healthy global demand is supporting US exports. I think the Fed is reasonably content the real economy is behaving more or less as it expects.

The minutes of the last meeting showed that some members of the Federal Open Market Committee [which decided on the rate rise] are clearly looking for an opportunity to pause in the tightening process. Mr Bernanke has said this would not preclude further tightening. What does this mean in practice? It's possible the FOMC might decide to pause in August, though given current market pricing (around 70% probability of another 25 basis point rate hike) that could be risky. More likely, I think we'll see another 25 basis point hike in August and then a pause. Even with a pause, I suspect the Fed will maintain its tightening bias. I expect further hikes to 6% early in 2007.

CRAIG JAMES, CommSec chief equities economist

The US Federal Reserve has recently been criticised for its communication strategy, but the latest statement is both very clear and very astute. Future rate hikes will depend on the flow of economic data. But, from where the Fed is standing, the economy is slowing and inflation expectations are contained, so there is no compelling reason to lift rates again.

It is always difficult knowing when to stop lifting interest rates, as the Federal Reserve knows only too well, lifting rates too high six years ago. It is important to slow growth to a sustainable rate but not so far that it produces a recession. But the Fed is right now in hinting at a pause in its rate hiking cycle. The US economy will slow in coming months, led by a weaker housing market. And strong domestic and global competition, together with solid productivity growth, should keep the inflation genie in the bottle.

It is very much in Australia’s interest for the US economy to grow at a solid, but sustainable rate. If the Fed has managed to engineer a soft landing then Australia will reap the gains in terms of continued firm demand and prices for our key resources.

The Reserve Bank won’t follow the US Federal Reserve in lifting interest rates. Australian economic growth is patchy while solid productivity growth, strong competitive forces and lower prices for foreign goods are restraining inflation. The prospect of a pause in the US rate-hiking cycle has weakened the greenback and pushed up the Aussie dollar. The Aussie dollar is likely to hug levels near US75¢ in coming weeks, representing good news for retailers and importers but more challenging conditions for manufacturers.

SHANE OLIVER, AMP Capital Investors head of investment strategy and chief economist

The Fed's 0.25% interest rate move came as no surprise to anyone. For investors, though, what mattered was that it was not the 0.5% hike that some had started to fear. More importantly, the Fed softened its view on the outlook for interest rates, leaving open the possibility that it might be finished raising interest rates, depending on how inflation and economic activity data unfolds going forward. While the Fed is clearly concerned about recent inflation data and sees the risks as remaining on the upside, it now seems more confident that growth is slowing and recognises that this will take pressure off inflation. Our view is that US interest rates have now most likely peaked (or if not are very close to it) and, as growth continues to moderate this, see inflation fears abate allowing the Fed to start cutting rates during the first half of next year.

The Fed's decision was taken positively by sharemarkets and metal prices. Commodities were also helped by ongoing signs of strong demand and constrained supply. The oil price also rose back above $US73 a barrel on falling US oil inventories and signs that Chinese demand remains strong. The oil price remains a risk over the next few months given the northern hemisphere summer driving season and the hurricane season in the Gulf of Mexico. The good news though is that both OPEC and non-OPEC sources are working on expanding their productive capacity, which may help ease the pressure on oil prices next year.

ROBERT DiCLEMENTE, Citigroup US chief economist

The statement accompanying today’s Fed rate hike to 5.25% kept alive better-than-even chances for additional tightening. But the undertone was not a one-sided validation of the forwards, which had embedded too high a probability of an overshoot in policy. The committee retained the judgment that there are still upside risks to inflation but in recognising signs of cooling demand it took an initial step toward a balanced view consistent with a near-term plateau in rates.

This message was not quite the one we anticipated despite its bias towards more firming. Our forecast of only one more hike in the funds rate to 5.5%, most likely in August, stands after today’s action. But the statement makes clear this is a highly data-dependent call just as today’s move proved to be following unsettling news about core prices and inflation expectations. Bernanke directed expectations abruptly once this decision materialised and markets again must confront the possibility of another volatile stretch.

Implicitly, the committee remains open to pausing even if tightening might have to resume. As a result, the announcement shaved the odds of an August move down from a near certainty to a 60/40 call, while modestly steepening the curve and lifting breakevens. Surprisingly, however, the statement provided virtually no forward-looking detail about economic growth, and even dropped references to sustainable (non-inflationary) activity. Barring compelling data, the uncertainty left by this statement will elevate further already sharp attention to the upcoming policy report to Congress at mid-month.

DR RON WOODS, Challenger head of investment markets strategy

Last night the US Fed raised rates for the 17th time at successive Federal Open Market Committee meetings. Interest rate uncertainty '” how many more and for how much longer will the US Fed raise rates '” have been negative factors for investors over the last few months. Unfortunately, this uncertainty could last a bit longer yet. In part that is because the Fed seems unable to know the answer to those two questions of how many more and for how much longer will cash rates rise. The Fed is still unsure of what to do next. Every piece of new and invariably volatile data has the potential to spook markets as the Fed reacts to it: "The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information," the committee said in last night’s statement. That new language replaced previous wording that said "some further policy firming may yet be needed". So while the statement last night hinted that more rate hikes could be coming, there were no guarantees other than more volatility. For example, last night investors thought the statement implied a pause at the next FOMC meeting and stocks surged. But next week or the week after, “strong” data could see investors fear more rate rises, “weak” data could raise the spectre of recession and the volatility continues.

That the Fed is uncertain makes the current climate much more problematic than almost any other time since the late 1990s. That is since the time, just over seven years ago that the Fed began to give forward guidance on changes in rates. Moreover, since mid-2003 when the cash rate had plunged to 1%, markets have been spoon-fed by the Fed. Since then the Fed gave quite specific projections about the cash rate, effectively six weeks notice of prior-intent. That changed in February of this year when the chairmanship of the Fed changed and a new spoon-feeder took over. Boy, can it get messy when you let a novice spoon-feed a child!