Market participants in the US and internationally held their collective breath on Wednesday morning as Chairman Greenspan testified to Congress on the long-term budget problems facing the United States. The testimony gave only an indirect clue as to his thinking about whether or not the next 25 basis point increase in the Federal funds rate would be agreed at the next FOMC meeting on September 21 or after the election. That same afternoon, the Fed released the Beige Book, the compendium of anecdotal information the various regional Federal Reserve banks compile from local business contacts.

The common message was that the US economy had encountered a soft patch this spring, which Greenspan attributed mainly to high energy costs. The production side of the economy had come out of that period with considerable strength, or as Greenspan put it “the expansion has regained some traction.” But the consumer rebound has been less vigorous and uneven across the country. One implication is unmistakable: unlike the internal debate within the Fed last June, just before the first increase in the Federal funds rate, the current discussion is not over whether to increase interest rates more or less forcefully, but rather whether to increase official interest rates at all this month.

Judging from the Chairman’s testimony and the regional Fed reports, there is evidently a reasonable case for taking a wait-and-see attitude this month, but the argument in favor of a September move appears to be winning out. The president of the Atlanta Fed, Jack Guynn, said as much in a press interview on Thursday.

What is the case for leaving the Federal funds rate unchanged this month?

1. The US stock market has been essentially treading water for months and is still nervous. Essentially investors are concerned about near-term earnings prospects and are uncomfortable with Chairman Greenspan’s vocal approval of narrowing profit margins. Why raise interest rates and risk a sell-off in the equity market merely weeks before the election?

2. The job market has cooled considerably since the spring and notwithstanding the better August employment report, additional improvement is not assured. Why risk being accused of stunting the expansion by premature tightening, should the job market get worse?

3. The value of the US dollar has to go down at least against Asian currencies in order to start a serious adjustment of the huge US trade imbalance. Why risk triggering an unhelpful rise in the value of the dollar by tightening again now?

4. A few sectors are in serious difficulty, most visibly the US airlines industry where the threat of additional bankruptcies is high. Why risk provoking new business failures?

5. Inflation has slowed from the admittedly strong lift during the first half of the year. Is a further interest rate hike needed now that the inflation rate seems to have stabilized, at least for a while?

6. The bond market has rallied strongly, a rally touched off by the weak job figures that provoked probably unreasonable fears of an imminent slowdown. Might not a further official rate increase in September simply stoke another rally on the grounds that it would be successful in stunting growth – and perversely undo whatever tightening intended in the Fed funds rate increase?

7. Some Fed officials believe that the "neutral" Fed funds rate – a rate that is neither stimulative nor restrictive -- may be a lot lower than market participants seem to think, maybe just 2% or a little higher rather than the 4% plus rate than has been discussed in the markets. Why not simply state that the process of reducing monetary accommodation is in process but does not entail interest rate hikes at every single meeting?

These arguments, however, will be weighed against another set of considerations that point slightly to a rate increase week after next.

Why tighten?

1. Most Fed officials are comfortable with their forecasts of a firming in growth, especially of the manufacturing sector. In the Beige Book, output growth was described as “solid” to “moderately improving” in the majority of Fed districts.

2. Shortfalls in consumption are explained by higher gasoline prices, unseasonably cool weather in the Northeast and Midwest, and hurricane disruption in Florida and some parts of the South. Income is rising at a good pace, and housing prices are only starting to cool off from high rates of increase. Together this points to eventual improvement in spending. Not to tighten gives the wrong signal: that weaker spending growth is expected within the central bank.

3. The inflation outlook is not entirely benign. That is evidenced not only by stubbornly high energy prices, which may filter into other prices over time, but also by shortages and price pressures involving a number of raw materials and intermediate products. Steel, lumber and transportation bottlenecks were cited, among others, by companies responding to the Fed district bank survey.

4. Since monetary policy works with a lag, and the Fed genuinely expects growth next year to be as fast or faster than the consensus, delaying inevitable tightening carries the risk of “falling behind the curve”, requiring higher rates next year than if the process goes ahead as planned “at a measured pace.”

One of the key determining factors of whether or not to raise the Fed funds rate is the outlook for the job market. Chairman Greenspan gave a subtle hint that he believes the employment situation may be improving, as evidenced by little known Government statistics measuring the rate of job openings. If the job market is doing better than the bond market now believes, a small rise in interest rates now would be warranted on the grounds of protecting against the need for more aggressive tightening later.

In short, Greenspan did not talk tough, which would have been a clear signal of an imminent tightening. He did not entirely ignore some of the arguments for holding rates steady, either, suggesting the debate has not been settled. There are still a few more data points left for him and his colleagues to consider before September 21. But he and other members of the policy-making FOMC are leaning toward a move. Thus, the odds have definitely increased that the decision will be to raise official rates another 25 basis points at that time.