When Fed Chairman Ben Bernanke took over the reins from Alan Greenspan back in February, it was widely believed that the Federal Reserve's campaign of monetary tightening was nearing its end.
It's August now, and the interest-rate hikes haven't ceased yet. But the long-awaited policy shift could finally be here.
New government data show unemployment rising and job growth slowing, raising expectations that the Fed may decide Tuesday that it has done enough to slow the economy and prevent a spiral of inflation.
A decision to pause from interest-rate hikes is not a slam dunk, however. Inflation hasn't slowed yet, and a new Fed chief typically faces pressure to prove his mettle as a defender of stable prices.
Tuesday's choice will help shape not only the economy's path but also Mr. Bernanke's public persona. As the world's most influential central banker, his communication and credibility are powerful forces in financial markets.
"This meeting is key," says Sam Bullard, an economist at Wachovia Corp., a banking and investment firm based in Charlotte, N.C. "We had Greenspan for so long, we were comfortable. We're still finding that comfort zone with Bernanke."
If the Fed takes a breather Tuesday, Bernanke will stake his early reputation on the virtue of patience. The move would signal his faith that, even though inflation may continue its upward trend for months ahead, prices will eventually be held in check by the impact of interest-rate increases already in place.
"Bernanke ... continues to be very mindful of the lags in monetary policy," says Peter Kretzmer, an economist at Bank of America in New York.
That's an important asset. History suggests it's common for inflation to keep rising even after the cause – such as a period of easy monetary policy like the one between 2002 and 2004 – has been corrected. It just takes a while for the fix to take hold.
In both 1990 and 2000, for example, the Greenspan-led Fed stopped lifting interest rates before recessions hit, at times when the "core" inflation rate (excluding volatile food and energy price changes) was still rising. Had the Fed kept tightening, those recessions would probably have been deeper.
Today, core inflation as measured by a monthly index of personal spending is up about 2.4 percent during the past year, above the Fed's desired range of 1 to 2 percent.
That's why Tuesday's meeting is so important.
The Fed's general goal is to guide the economy along the smoothest possible track, providing enough monetary fuel for healthy growth, but not so much that inflation takes off. Inflation can cause long-term harm by damaging the confidence of investors and consumers in their purchasing power.
But in the current economy, the Fed has reached a point where the line between too much tightening and too little is hard even for experts to draw.
And Bernanke himself is still working to win the confidence on Wall Street. To his critics, his early months were marred by mixed signals.
Now, just as he seems to be doing better at staying "on message," economists, including some at the Fed, differ regarding what the message should be.
"I think Bernanke's over the hump in terms of credibility," says David Malpass, an economist at the investment firm Bear Stearns in New York. "He's not new on the job anymore, and markets are clearly showing a lot of respect. The issue is not so much personality as data."
The latest signals suggest the economy may be downshifting toward slower growth.
In Friday's jobs report, the nation's unemployment rate rose to 4.8 percent, up from 4.6 percent a month ago. And employers have been adding only about 112,000 jobs monthly from April through July, down from an average of 170,000 for the 24 months before that. To many observers, those numbers suggest that past rate hikes are having their desired effect, and that Bernanke can hit the pause button.
The chairman's recent testimony to Congress reflects this view. "The anticipated moderation in economic growth now seems to be under way," Bernanke said July 19. And he reminded lawmakers that monetary policy takes effect only after a long lag time, with impact on future inflation already "in the pipeline."
Careful to counter the "dovish" label, he also said that inflation risks remain. Energy prices, for example, could always spike even higher.
But Bernanke appears to expect that once economic growth cools a bit, inflation will eventually subside as well.
The Labor Department, however, also reported a rise in wage growth Friday. That's a good thing, but economists watch such numbers carefully for signs that salary pressures might become part of an inflationary cycle. Unless worker productivity is keeping pace with wages, employers might have to boost product prices to cover their higher labor costs.
This means that another economic report – one on productivity that's released Tuesday morning – could be decisive for Fed policymakers.
"We think they will tighten, but it's a very close call," says Ed McKelvey, an economist at Goldman Sachs in New York. "The productivity numbers are important."
The case for another rate hike, and possibly more before the end of the year, involves several factors:
•Some economists don't believe that the Fed has successfully erased the easy monetary conditions that it established for several years after the recession of 2001 and the 9/11 attacks. They still see "excess liquidity" as a global problem that central banks are now facing from Europe to Asia.
•Just as faster-than-average rises in worker productivity helped keep inflation low for much of the past decade, now a slowdown in productivity may be nudging prices higher.
•Expectations need to be contained. If consumers and corporations start anticipating more inflation, that can become a self-fulfilling prophecy.
•Some economists believe economic growth will strengthen in the months ahead from its 2.5 percent annualized pace in the second quarter. In that scenario, an expected housing slowdown would not be enough to drag consumer spending, or hold inflation in check.
Other forecasters are more concerned about signs that point to a slowdown and even a possible recession.
Economists at Merrill Lynch put it this way in a report Friday: "We think today's employment report in its entirety should put the Fed on hold, not just next week but through to the end of the year."