Federal Reserve & Interest Rates

The credit crunch is still here, commodity prices continue to rise and equity markets have lost nearly 20% from their highs last fall, yet economic growth is expected to remain positive through the summer on the strength of stimulus checks that started arriving to millions of Americans back in May. 

While much of the increase in consumer spending in recent months has been attributed to inflation, there was a noticeable increase in non-food and energy spending in May which has benefited the retail sector especially.

A couple of months back, many financial experts were stating that the worst was behind us, but the fact of the matter is the current economic doldrums could very well last another year at the least.  Despite the best efforts of the Fed to pump billions of dollars of liquidity into financial markets as well as the government sponsored moratorium on Adjustable Rate Mortgage increases, the housing market remains in a deep slump.

As delinquencies and foreclosures keep rising, it is becoming more and more likely that writedowns for financial firms will continue to grow for the next few quarters.  Tighter lending standards and rising mortgage rates have helped curtail demand and coupled with the glut of unsold homes it is apparent that a recovery will not take place anytime soon.

Right now investors are reacting strongly to any type of negative news.  In the first two weeks of June Treasury yields climbed on inflation concerns as investors retreated from fixed income markets only to fall sharply as a slew of bad earnings reports sent equity markets tumbling and started the flight to quality once again.

There are a lot of things wrong with the economy right now and once the gravy train runs out though, all bets are off. With consumer confidence levels at their lowest point in years it is quite possible that sometime in the fourth quarter or early next year, we could finally see the long awaited recession many American have been expecting for some time.

The Federal Reserve Board’s decision to hold interest rate steady at 2% mirrors the current state of the economy, which is a holding pattern.  The Fed is torn between placing emphasis on slowing economic growth or rising inflationary pressure from the commodities market.

Economic data released today reaffirms this situation, according to the Labor Department jobless claims stayed the same from a week ago at 384,000.  The Bureau of Economic Analysis released it’s final revision for Gross Domestic Product for the first quarter raising it to 1% up from 0.9% from an earlier revision made last month.

While these aren’t great numbers, the economy is faring slightly better than what most economists were predicting.  Although it does appear we are entering a period of stagflation, it is no where near the scale of which the economy faced in the 1970’s.

The Commerce Department released figures showing that sales of existing homes climbed slightly last month to an annual rate of 4.99 million homes up from a record low of 4.85 million homes in April.  Although declining prices have spurred some buyers back into the market, the housing slump is expected to continue for the foreseeable future as the inventory of unsold homes accumulates with mortgage rates climbing in recent months.

Consumer spending numbers have received a recent boost from economic stimulus payments but much of the increase can be attributed to rising energy and food prices.  However, falling consumer confidence levels and a weak outlook on job growth is expected to have a negative impact on spending once those payments run out.

More writedowns are expected to hit the financial services sector as firms will need to revalue bond portfolios with some of the major bond insurers being downgraded to little higher than junk bond status.  Still we need to keep in mind that most of these writedowns will not actually become realized losses and that while much of the municipal bond market has been devalued, it still has a strong history of low default rates unlike collaterized debt obligations from the residential mortgage market.

As ratings agencies slowly adjust municipal credit ratings to more closely match the standards of the corporate bond market we should see some of these writedowns disappear.  However, rising defaults and foreclosures in the housing market will still affect those with the greatest subprime exposure. 

Until the economy signals to the Fed which direction to go to, rates will most likely remain steady though out the summer. 

The Federal Reserve is meeting today to discuss monetary policy but no change to interest rates are expected.  While the Fed’s stance on the economy has shifted somewhat in recent months, placing more of a focus on inflation, the weakening financial and housing markets will most likely keep their hands tied.

Americans in the lower income classes are bearing the brunt of the current economic slowdown with consumer confidence falling to their lowest level since the 1992.

Consumers, whose spending accounts for more than two thirds of gross domestic product, are being hurt by the housing slump, rising unemployment and higher food and fuel bills.

Recent economic data “suggests we are on the brink” of a recession in the U.S., former Federal Reserve Chairman Alan Greenspan said today via satellite to a conference in Johannesburg. The next year will be “a very sluggish period,” with a “highly volatile oil market,” he said.

The lone bright spot in the economy has been the export sector which has benefited greatly from the weak dollar and while the country still runs a trade deficit, it has shrunk to it’s lowest level in years.  However, high fuel costs are starting to put a damper on global trade as a whole with shipping costs rising to compensate.

The relative decline in competition from imports has also allowed domestic manufacturers to raise prices which has helped contribute to higher inflation expectations.  Although consumer spending continues to rise while the economy slows, that can be solely attributed to higher prices.

The Fed is currently in a “no-win” situation, currently both inflation and recession are significant threats to the economy and until one of them tips the balance, the Fed will most likely keep rates stable.