Finance news

Economic growth should strengthen over the next 18 months as the current level of interest rates promotes growth and moderates inflation, Federal Reserve Vice Chairman Donald Kohn said today.

“Monetary policy appears to be appropriately calibrated for now to promote both rising employment and moderating inflation over the medium term,'' Kohn said in the text of remarks to the National Conference on Public Employee Retirement Systems in New Orleans. “But a large measure of uncertainty surrounds that judgment and as the economy evolves, so will the appropriate stance of policy.''

Central bankers, having cut the benchmark interest rate by 3.25 percentage points since September, are trying to sustain economic growth without intensifying inflationary pressures caused by record prices for oil and other goods.

Kohn's remarks suggest the Fed is likely to leave the main rate unchanged at 2 percent at their two-day meeting on June 24- 25. Federal funds futures traders see a 90 percent probability that central bankers will leave the benchmark rate unchanged in June. However, Kohn didn't close the door to further cuts, noting there are large uncertainties surrounding his forecast for stronger growth in the second half of this year.

“Uncertainty about how credit conditions will evolve and how businesses and households will react to changing terms and conditions means that we can have even less confidence than usual in our economic forecasts,'' said Kohn, 65.

Low interest rates and a gradual easing of financing conditions, and tax rebate checks should boost growth over the next 18 months, Kohn said.

Economy Firms

“The most likely scenario over the next year or so is one in which economic activity firms during the second half of this year and then gathers some strength in 2009,'' Kohn said. “I expect further, but gradual, improvement in financial markets.''

The collapse of the subprime-mortgage market and the worst housing slump in a quarter century have led to reduced consumer spending and estimates by economists of just 0.1 percent growth this quarter. Financial institutions are reluctant to lend to one another, having reported $379 billion in credit losses and asset writedowns since the start of last year.

“A number of factors suggest that the recovery could be relatively moderate,'' the Fed vice chairman said.

The number of banks reporting tighter lending standards approached a record in April, according to a Fed survey. Businesses have cut jobs for five consecutive months.

The Federal Open Market Committee said “substantial'' interest rate cuts over the past 12 months “should help promote moderate growth over time'' at the conclusion of their April 30 meeting freecreditreport.

Prices Rose

U.S. consumer prices rose less than forecast in April, reflecting cheaper furniture and lodging costs, the Labor Department said May 14. Prices rose 3.9 percent in the 12 months ended in April, down from a 4 percent year-over-year gain in March.

Oil prices rose further in May, hitting a record today of $127.84 a barrel on the New York Mercantile Exchange. Food prices rose at a 6.1 percent annual rate for the three months ending April, according to the Bureau of Labor Statistics.

Rising commodity prices add to inflation pressures and damp demand for other goods, Kohn said. “A tendency for increases in commodity prices to become a factor in ongoing pricing and wage- setting more generally would be a worrisome development that would over time tend to undermine economic welfare,'' Kohn said.

The Reuters/University of Michigan Survey of households showed inflation expectations rising to 5.2 percent over the next 12 months, the biggest jump since 1982. Five-year inflation expectations rose to 3.3 percent in the survey, the highest since August 1996.

`Moderating Inflation'

“My expectations for moderating inflation and limited spillover effects from commodity price increases depend critically on the continued stability of inflation expectations,'' Kohn said.

Construction of U.S. single-family houses in April dropped to the lowest level in 17 years. Builders broke new ground at an annual rate of 692,000 homes, the fewest since January 1991. Residential investment, a component of the gross domestic product account, has declined for nine consecutive quarters, and subtracted about a percentage point from the economy's 2.2 percent expansion last year.

“The supply of existing homes on the market also remains quite high and is likely to be augmented in coming months by rising foreclosures,'' Kohn said. “As a result, further cuts in construction appear to be in train.''

Curtail Risk

Borrowing costs have increased as financial institutions curtail risk. The central bank has increased liquidity for banks and bond dealers through three new lending tools, as well as an expansion of its existing programs. The spread between the three-month London-Interbank Offered Rate and U.S. three-month Treasury bills has narrowed to 82 basis points, the lowest since Feb. 14. The difference in yield was 203 basis points on March 19. A basis point is 0.01 percentage point.

“Improvements in financial markets are vulnerable to negative news on the economy or the extent of credit losses,'' Kohn said.

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