The Feds Next Move

The Feds Next Move
Rising inflation, slowing and turbulent markets fearful of interest rate hikes and other contributing factors like: oil that can rise and drop two dollars a barrel in one day but keeps hovering around $70, downward trends in new-home demand figures, businesses are raking in profits at an ever faster pace, unemployment keeps edging down and wage growth keeps edging up (though job growth has been mixed recently), and in the face of all this US Treasuries and the Dollar have rallied and consumer confidence and spending have dipped raise many questions. Like, how will the Fed proceed in light of such a muddled picture? As the old joke about how porcupines make love goes: ?Very carefully?. In June the Fed will meet to discuss whether or not to increase the Feds Fund Rate another quarter of a point or not (a larger increase is seen as almost as unlikely as a decrease due to the markets already being spooked, among other factors) .The main problem, but by no means the only inputs to this equation nor the only one I?ll discuss, is that the Fed seems to be caught between its main objectives of low & stable inflation and high & stable growth coupled with finical system stability (in the form of investor confidence waning). The pce index measure of inflation is above many Fed governors, including Bernanke, stated comfort zones. Knowing this, many in the markets are expecting another hike, but this is already having negative effects on the markets. That coupled with things like dropping consumer spending and confidence (partially due to oil) and an apparently declining housing market have created a camp that thinks that raising rates may cause the economy to stall or even dip into a recession. Coupled with mixed signals from the Fed, many of which are pretty open to interpretation, and you can see why the markets are left guessing. When the Fed isn?t sure what it will do next, how can the markets? They can?t, but they can look at the data available for hints:
Inflation is currently been at 2.5% for the first three quarters of 2006 and around 2% for about a year prior (pce index), while from a purely economic standpoint you could spin that either way, year old quotes from Bernanke and other governors have spooked the market. Before he was the Fed chair declared his comfort zone as being 1-2% inflation on the pce index, which is currently leading to a lot of speculation in the markets that the fed rate will be raised again in June to help battle inflation. And again in May, the cpi increased another .3%, this for the third month in a row. Coupled with things that are not considered in ?core? inflation but obviously matter, growing energy costs largely due to oil that remains high and threatens to go higher as political conflicts with countries like Venezuela and Iran continue and increasing food prices, it?s easy to see the dangers these present to both the consumer directly and the danger they posse in ?spilling over? into other markets. Yet, other indicators seem to show that inflation outside of things like energy and food isn?t read to take hold. Recent revisions have shown that labor costs didn?t rise as sharply as expected in recent months and productivity is better than first thought. This leaves earning potential solid, hence there isn?t much need for rising prices as of yet as the rising costs of things like energy seem to still be getting absorbed. These factors show, along with another strong for profits, eases inflation concerns some. Then there are mixed indicators, like take home pay being revised downward, remaining above inflation, but not by that great amount. Inflation still appears to remain the top concern currently of the Fed, but not necessarily its most pressing concern, which may be the economy coupled with investor confidence.
The weak footing of the economy is another major concern. The markets, due to Bernanke?s previous comments seem to have been expecting a rate hike in June, till even more muddled data and revisions came in late in the month. Markets have been down recently, the Dow Jones has suffered triple digit loses with all 30 of its components declining, the S&P also lost ground, and the nasdaq slipped into negative territory for the year. In fact, all this uncertainty seems to be having an effect on the European and Asian markets as many have finished down recently. Housing has also started to dip in demand and most forecast are poor, though few expect to see housing ?burst?. These factors and gas seem to be chipping at consumer?s confidence levels and spending. Spending isn?t expected to get past 2% for the full first quarter and now consumers are out spending their income by -1.6%, a record low. Other factors spurring growth in the early months of the year are fading, like the warm winter and ?post-hurricane rebounds? are now gone or diminished. All of this weakness would suggest taking a break on rate hikes and adopt an approach that holds till either inflation rises or economy and markets stabilize. Others argue that the market declines have already priced the hike into the market and that rising inflation has the potential to do more harm than the hike itself. This is coupled with the perception the markets have about the Feds willingness to fight inflation. After listing their comfort zone and then letting inflation rise above it with no action, the Fed may loose some credibility in the markets eyes. This may cause less ?pricing in? of other future rate hikes and less predictability in the bond markets, leading to possible further destabilization of the economy. In the long run, coupled with inflation, some argue that may be more hurtful to the economy than the hike itself. So you have markets that are fearful of both a rate hike and inflation. You have investors who want the Fed to stick to its word about inflation and raise rates and you have those that want a break from hikes to let the markets catch their breath. So what is the Fed supposed to do? It seems they will get few clues from other contributing factors.
Oil has been in flux for awhile now, but generally holding around $70 per barrel. With opec just announcing that there will be no increase in supply until at least their next meeting, it is likely to stay about there. Higher oil prices threaten to increase the price of many goods in the ?core? inflation indexes. There seems to be a silver cloud with a dark lining though. The good news is that gasoline prices in recent weeks have began to drop, about 2.2% and demand for oil is leveling off heading into the peak driving period. While that?s a good sign, it marks about a 1% drop off in demand, showing the consumer has been so far been able to deal with the increase in price. So it seems, at least for now, prices will continue to drop if conditions remain positive. That?s the silver cloud; the black lining is the current risks. The situation in Venezuela and especially Iran could result in hire gas prices and ?tough talk? by the two sides could raise price in the market by itself. The other risk looming the start of the hurricane season, which is predicted to be active, that last year resulted in record prices last September after Katrina. Again, some positive news, some negative news. Again muddled. Another factor the Fed may look at is the Job market. The May Jobs report was 105,000 jobs short of expectations. It also contained downward revisions for the last two months equaling a ?loss? of 37,000 jobs. Lower forecasts for many economic reports were quickly followed by increasing worries of a slow down in the economy.
What I think the Fed should do, and what I believe the Fed will do, is raise rates again. I should be clear though, it?s close in my opinion, and time still remains before the committee meets. Chicago Federal Reserve President Michael Moskow came out today supporting such action (without actually saying it), while that doesn?t necessarily mean anything, as many expected split opinions when the Fed met, but it may signal the way some members are leaning. I think the Fed should raise the target rate because if interest rates get out of hand they can weaken the economy by themselves and I think the recent market declines have been do to the market pricing the rate hike so the immediate effect on the markets will be minimal. Possibly a better reason is to reassure the markets that the Fed still has controlling interest rates as it?s number one priority and to show that it is willing to raise rates to bring the interest rate level back in-line with their 1-2% ?comfort level?. It?s essentially the lesser of two evils. This is not, however, a mandate on future rate hikes. The economy is in flux and must be closely watched. Another quarter of a point might be where you pause in your rate hikes for awhile, but since the economic conditions are fairly cloudy (it?s hard to predict the next rate hike much less ones after that) there is no real point in guessing at those. What I do believe is that the Fed doesn?t have that many more rate hikes left before the economy starts to react very negatively. So when that last hike comes, I think it may the last one for the year.

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