WASHINGTON, Jan. 5 (UPI) -- Stocks are gaining ground, business spending is on the rise, and both suggest that the U.S. economy could well be on an upward climb to steady recovery as the nation gears towards a presidential election in November. But as policymakers of the Federal Reserve prepare to meet for the first time this year later in the month, one thing is clear -- whether the Fed decides to keep interest rates at their 40-year low of 1.0 percent for some time to come or not, both options could potentially hurt the still-shaky recovery.
For now, the odds seem to be that the Fed will keep interest rates steady at least for a while. Late Sunday, Federal Reserve Governor Ben Bernanke told members of the American Economic Association in San Diego that 2003 was a "turning point for the U.S. economy, and we have reason to be optimistic that 2004 will see even more growth and continued progress in reducing unemployment."
At the same time, Bernanke, who is regarded by many Fed watchers as a potential candidate to replace current Fed chairman Alan Greenspan if he decides not to continue for another term when his current appointment expires in June, said that inflation remained low and likely to remain so.
"In my view, weighing the relative costs of the upside and downside risks also favors accommodation (of historically low interest rates); in particular, it is important that we ensure, as best we can, that the current expansion will become self-sustaining and that the inflation rate does not fall further," Bernanke added. The 49-year-old former Princeton University economist is renowned for as an inflation-target advocate, arguing that a target rate for inflation will prevent investors and businesses from building expectations of higher inflation, which would in turn make it less likely that inflation -- or indeed deflation -- would occur.
"For now, I believe that the Federal Reserve has the luxury of being patient," he added.
Thus, the central bank governor effectively denied that the Fed will assume its often unpopular role of taking away the punch bowl to prevent things from overheating, just as the party starts picking up.
Granted, on Monday, the president of the Federal Reserve Bank of Atlanta told the Atlanta Rotary Club that monetary policy must move "at some point." However, the Fed's Atlanta head, Jack Guynn, did not specify when that time might be, and instead echoed Bernanke's view that inflationary pressure was firmly under control.
"I would suggest that the timing of policy actions (for raising rates) should not hinge on 'calendar time' but rather 'economic time'. Given the forecasts we have at this time, I want to emphasize that I see little threat that inflation is poised to rise significantly," Guynn said.
Nevertheless, some analysts fear that with the economy steadily gaining steam over the past few months, with third quarter GDP reaching an unexpectedly strong 8.2 percent, inflationary pressure will force the central bank to tighten monetary policy sooner rather than later.
Indeed, fears that the Fed will not react swiftly enough to prevent the expansionary trend from overheating has increased in some quarters.
"Needless to say, we are not persuaded by Bernanke...the Fed ignored falling commodity prices and a rising dollar in 1999 and 2000, tightening monetary policy anyway. The result was a recession and deflation. Obviously, the Fed did not learn from this mistake. This time the Fed is making the same mistake, but in the opposite direction. The result will be rising inflationary pressures and bond yields," argued Brian Wesbury, chief economist at investors Griffin, Kubik, Stephens & Thompson who pointed out the need for monetary tightening relatively soon.
Moreover, the U.S. dollar has weakened further since Bernanke's speech, as investors seeking higher-yielding currencies sold off greenbacks for euros and yens at a time when the United States needs capital inflows to compensate for its ballooning current account deficit. Indeed, the dollar has fallen to yet another all-time low against the European currency at around $1.26 to the euro, while the dollar is only slightly above 106 yen. Talk of interest rates remaining low for some time also led U.S. Treasuries to slide during Monday's trading as well.
Yet, the decision to keep monetary policy pat or to raise interest rates could be a no-win situation for the Fed. If the Federal Open Market Committee does vote to tighten rates within the next few months, it could lead to credit crunch and a potentially burst in the real estate market. The housing market has been critical in keeping the economy afloat over the past few years since the burst of the dot-com bubble, which kept going from strength to strength as a result of record-low mortgage rates. A rate hike would lead to borrowing costs to surge, which in turn could force many homeowners to default on their payments and either sell their house or file for personal bankruptcy that would prove detrimental to overall personal consumption.
The FOMC next meets for two days on Jan. 27 and 28.
