FOMC: Inflation Remains Predominant Risk In US

U.S. Federal Reserve officials remain focused on battling inflation, despite a recent run of lower consumer price inflation and an improving forecast for moderate economic growth, according to the minutes of the Fed's most recent policy-setting meeting.

Participants at the Federal Open Market Committee's June 27-28 meeting agreed that "the risk that inflation would fail to moderate as expected remained their predominant concern," the minutes said. But the Fed sounded a more sanguine note on economic growth since its prior interest-rate meeting, saying business investment and a strong labor market suggested "that the risks to growth were more balanced that at the time of the May meeting, despite the ongoing adjustment in the housing sector." The Fed said it expected economic growth to rise gradually "to a pace close to that of potential output." FOMC members expected inflation "would probably edge lower over the next two years, reflecting the waning of temporary factors that had boosted prices last year and a slight easing of pressures on resources." Despite recent improvements in consumer inflation data, the Fed remained wary of drawing any conclusions about future downward trends in price pressures, echoing the Fed's post-meeting June statement. "Recent data on core consumer prices were encouraging ... but participants were wary of drawing firm conclusions about future trends from a few monthly readings." The Fed elaborated, saying monthly consumer prices are often "noisy," and recent readings on core inflation "seemed to have been depressed by transitory factors." Moreover, the Fed warned that high resource utilization, higher energy and commodity prices, the falling value of the dollar and slower productivity growth could "sustain inflation pressures."

Fed Has Kept Rate Unchanged At 5.25%

Inflation is running at a 1.9% annual rate as measured by the Fed's preferred gauge, the personal consumption expenditures price index excluding food and energy. That is down considerably from where it was when Bernanke testified in February and within the Fed's understood comfort zone of 1% to 2%. But in a sign that officials remain unconvinced about how permanent those disinflationary trends are, the Fed in its semiannual report to Congress on Wednesday held to its February forecast that core PCE will be between 2% and 2.25% this year. According to the minutes of the June meeting, the Fed noted that while core inflation has receded, headline inflation has risen following higher food and energy costs. That rise in headline inflation could cause a corresponding increase in the public's inflation expectations. "While total inflation is expected to slow toward the pace of core inflation over time, a number of participants noted that recent elevated readings posed some risk of a deterioration in inflation expectations," the minutes said. With that in mind, "several participants" in the June meeting "emphasized that holding long-run inflation expectations at or below current levels would likely be necessary for core inflation to moderate as expected over coming quarters." The Fed has kept the federal funds rate unchanged at 5.25% for more than one year, and is increasingly expected to hold it there well into 2008. With the question of rates seemingly settled, Fed watchers have focused increasingly on what the Fed's specific long-term inflation goals are. The Fed doesn't have an official inflation target, but has long been assumed to have a comfort zone between 1% and 2% for annual core PCE growth. That index was at 2% when the Fed met in late June, but softened further to 1.9% when May figures were released after that meeting.

Housing Market Likely To Continue To Contract

Turning to the housing market, the Fed said the sector "represented the most significant downside risk to the economic outlook," and it was "likely to remain a drag on growth for some time yet," according to the minutes. "Housing activity was seen as likely to continue to contract for several more quarters," the minutes said. Despite the housing recession, consumer spending has remained strong, and the Fed said "spillovers from the strains on the housing market to consumption spending had been apparently quite limited to date." The minutes also dug a little deeper into the status of labor markets, which remain robust, despite relatively slow overall economic growth. In fact, "the continued tautness of labor markets was something of a puzzle in light of below-trend growth over recent quarters, and this development seemed to be connected with slower productivity growth lately," the minutes said. Meeting participants said that employment data for 2006 could end up being revised down, or that employment "adjustments" could be lagging behind economic conditions. Some participants posited the following explanation: The level of the unemployment rate "consistent with stable inflation could be lower than previously thought - a possibility that would help to explain the absence of outsized wage pressures in the current environment."