The Fed: Time for a Vacation.

What will the Fed do next?  They are scheduled to meet again in August.  In thinking about their next move, I ask myself, what would I do if I had Bernanke’s job?  I’d ponder two aspects of economic theory.

First, reported inflation lags economic activity.  The full effect of the last year’s interest rate increases have not yet shown up.  So there’s some downward pressure on inflation in the pipeline.

Second, inflation triggered by oil price increases is a little different than inflation from generic excess demand.  It’s not entirely different, but oil price hikes tend to push up inflation and depress real economic activity.  Depressing real economic activity should, eventually, lower inflationary pressure.  Thus, the Fed does not have to be so vigilant against oil-induced inflation as it would otherwise be.  However, it should not totally ignore such inflation, because that would lead to excessive monetary expansion to fight the weaker economic activity, and the oil-inflation becomes embedded throughout the economy.

These are the two key theoretical aspects to consider.  Now add in the economic facts.  The real fed funds rate is about three-quarters of a percent above its long-run average.  That should nudge—but only nudge—down the rate of economic growth.  However, we’re also seeing signs of slightly slower economic growth in the economy.

Looking forward, I think it’s time for a pause in the Fed’s rate hikes.  The futures markets think that a pause in August has about a 50-50 probability.  I believe that the Fed will look at the data between now and then; nothing is locked in at this point.  However, I expect some further weakening in the housing market and in auto sales to make the Fed comfortable doing nothing in at their next meeting.  I recommend, and forecast, that they take a vacation in August.