Fed lets the monetary throttle go in the midst of uncertainty about the economy

On August 8, the Fed decided to stop increasing the target for the federal funds rate, now at 5.25%. Futures markets gave the pause a 50/50 chance against a further quarter point increase, highlighting the high degree of uncertainty about the economy. Wall Stree Journal reporter Greg Ip put it clearly in today's column:

``The Fed is entering what has traditionally been one of the most delicate phases of the business cycle. The economy has reached full strength and inflation pressures have built.

There are signs that higher interest rates are slowing the economy, but it remains unclear if they have slowed it enough -- or too much. The Fed paused at a similar point in February 1995, and in May 2000. The first time, the economy had a "soft landing" -- slow growth followed by five more years of expansion. The second time, it fell into recession."

In the August 8 press release, the Fed states that

``...the Committee judges that some inflation risks remain. 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."

Given the high degree of uncertainty about where the economy is and about the effect of previous monetary policy actions, the option of waiting for some of the uncertainty to clear is very valuable to the Fed. But where does this uncertainty come from?

Economic growth has moderated in the second quarter as a result of (i) the cooling housing market; (ii) higher prices overall, and energy in particular, that have decreased households' real incomes; and (iii) increasing interest rates. With the economy at full capacity and increasing prices, there is a risk of inflation, and an increase in expected inflation, if the effect of prices is transmitted to wages. If wages rise, with a slowing aggregate demand, the economy could fall into a recession.

Although labor markets appear tight in some sectors, particularly for skill intensive jobs, there does not seem to be a worrying effect on wages (to the Fed at least). In fact, the Fed deleted a statement about labor markets from the June's press release.

Thus the picture that the Fed seems to have is one with moderating aggregate demand and inflation, so that it does not need to increase rates further at this point. A further rate increase can be expected if labor markets and aggregate demand do not paint the same picture in the near future.

The option to wait that the Fed is exercising is also not as passive as some may think. Because the Fed is open to raise interest rates at the next meeting, long term rates remain relatively high and thus should help contain aggregate demand.