Why the Fed isn’t going hiking this year

April 4, 2011, 2:37 PM UTC

Don’t get carried away by Friday’s upbeat jobs report.

The recovery has hit a “soft patch,” Goldman Sachs economists said in cutting their first-quarter gross domestic product growth forecast to 2.5% from 3.5%.

Not the whole story, alas

Though the shrunken manufacturing sector is bouncing back robustly, weakness in housing and falling consumer confidence “suggest softening in other areas,” Goldman economist Jan Hatzius wrote in a note to clients Friday.

Goldman’s growth downgrade says it’s time to hit the brakes on the Fed-tightening express. Even before we learned Friday that the economy added 216,000 jobs last month, rate-hike talk was picking up steam last week amid the latest hawkish scratchings from regional Fed bank presidents.

A modest pickup in inflation readings this year “might be a reason to tighten by the end of the year,” Minnesota Fed President Narayana Kocherlakota said last week. He claimed, astonishingly enough, that a half-percentage-point rise in core inflation since the end of last year could prompt the Federal Reserve to raise its overnight lending rate to 1% by the end of 2011.

Talk about wishful thinking. Consider that the latest core inflation reading was just 1.3% and Fed chief Ben Bernanke has committed himself to raising inflation toward the Fed’s long-run target of just under 2%.

But that’s not the only reason to expect the Fed to stay on the sidelines for the next year or two. Hatzius notes that as lazily as the United States is approaching its inevitable belt-tightening, when the spending cuts do start they will slow the economy – which will pressure the Fed to keep holding rates down, regardless of what food and fuel prices do.

That would be the case even if the United States had to tighten its belt only a notch or two. But the primary fiscal deficit – spending minus revenue, excluding interest costs – is on track to hit 6% this year, a gap the size of which has rarely been seen. Americans have their work cut out for them in coming years, and the Fed won’t want to be painted as having stood in the way of the economy moving toward a healthier balance.

“The impending fiscal adjustment over the next few years is a strong argument to keep monetary policy easier than it otherwise would be,” Hatzius writes.

He points by example to the inflation outbreak in the U.K., where headline inflation recently topped 4% and core inflation – excluding fuel and food costs – was 2.4%. Though policymakers there are expected to raise rates as soon as this spring, rates aren’t likely to rise as much as an analysis like Kocherlakota’s might suggest is on offer.

That’s why, even though Hatzius projects the U.S. economy will return to a 4% annual growth clip for the rest of 2011, Goldman doesn’t expect the Fed to raise rates until 2013 — whatever the Kocherlakotas of the world might say.

“Fed officials are unlikely to be as tolerant of higher inflation as their U.K. counterparts,” Hatzius writes, “but the prospect of fiscal adjustment does suggest that the funds rate will rise more slowly than is now widely expected.”

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