Federal Reserve & Interest Rates

Federal Reserve Chairman Ben Bernanke gave a speech today at an annual economic symposium that sends more signals to the market that with inflationary pressures abating somewhat recently interest rates will stay at their current level for some time.

In view of the weakening outlook and the downside risks to growth, the Federal Open Market Committee (FOMC) has maintained a relatively low target for the federal funds rate despite an increase in inflationary pressures. This strategy has been conditioned on our expectation that the prices of oil and other commodities would ultimately stabilize, in part as the result of slowing global growth, and that this outcome, together with well-anchored inflation expectations and increased slack in resource utilization, would foster a return to price stability in the medium run.

In this regard, the recent decline in commodity prices, as well as the increased stability of the dollar, has been encouraging. If not reversed, these developments, together with a pace of growth that is likely to fall short of potential for a time, should lead inflation to moderate later this year and next year.

The price of oil has been quite volatile the last two days, rising $6 on Thursday only to fall another $6 today.  Traders are watching movement of the dollar very carefully which is why we are seeing big swings in the commodities market.

There are also widely varying views on the future movement on the price of oil.  Some analysts are saying crude will be back to the $150 level by the end of the year, while others are predicting that oil will fall to $80 within 12 months.

Oil’s recent slide can be attributed to two dynamics, a strengthening dollar and weakening global demand.  It’s future movement could well depend on how foreign economies fare in the next six months, the worse off they are, the stronger the dollar will be, which is a major driving force of commodities markets at the moment.

In July, the European Central Bank raised interest rates by a quarter percent in order to combat inflation which is averaging at a 4% annual rate.  It’s really an interesting situation, normally if interest rates rise in another country it would put negative pressure on the dollar.

The European Union’s economy already showed signs of shrinking in the second quarter and last month’s rate hike isn’t going to help matters.  So while currency traders might not necessarily be bullish on the greenback they could very well be growing bearish on the Euro which would spell good news for commodity prices and inflationary pressures in this country.

The stock market is rallying on the heels of falling oil prices, which are at their lowest levels since the beginning of May.  Despite the conflict that erupted between Russia and Georgia that threatens oil pipelines, oil continues it’s free fall, retreating nearly $35 from it’s July high.

“It’s become clear that demand is cratering, which is making it hard to rally,” said Rick Mueller, director of oil markets at Energy Security Analysis Inc. in Wakefield, Massachusetts. “It’s hard to imagine that the market will shrug off the potential loss of 1 million barrels a day of pretty good quality crude but that appears to be the case.”

Oil producers have long stated that the natural price of oil should be around the $80 a barrel mark.  Heavy speculation and a falling dollar pushed oil above $100 at the start of the year and close to $150 by mid July.

Demand is falling across the globe so unless there are significant disruptions to supply, the price of oil could continue to fall.  There is no question that oil is the leader of the commodities market and it’s slide is having a spillover effect on the rest of the market.

Traders are leaving the commodities market in droves and pumping some of that money back into the stock market, fueling a rally that some experts feel could last a few weeks.  The bubble is bursting for commodities in general and it looks like the Fed was correct when it predicted that inflation pressures would ease as global demand cooled.

The stock market is taking advantage with it’s largest weekly gain since April.  So far, shipping and transportation companies are benefiting the most from falling fuel prices.

Although the decline in the price of oil is getting most of the attention, commodities have been retreating across the board for the last two weeks.

“People have gotten very worried about demand for commodities because of this global meltdown,” said Michael K. Smith, president of T&K Futures & Options in Port St. Lucie, Florida. “If all these major economies are going to slow down, people think that’s really bad news.” 

When the dollar started it’s free fall last year and inflation started to rear it’s ugly head, we saw large amounts of institutional money pouring into the commodities market.  Commodities were one of the few outlets for investors that provided decent returns with the bond, stock and housing markets all in decline.

So much money went into these markets over such a short period of time, a speculative bubble couldn’t help but form.  Unfortunately with the economic troubles that began in this country slowly spreading around the globe, that bubble is starting to burst.

On one hand it seems as if some of the inflationary pressures are starting to abate, which is the good news.  On the other hand, the reasons for this is not because conditions are improving in this country but that the rest of the world is falling to our level.

For example the dollar has been gaining in exchange markets recently but instead of thinking of the dollar as growing in strength, it’s more like foreign currencies are weakening with their respective economies.  Consider that interest rates in the U.S. are comparatively lower than much of the world, which serves to drive down demand for dollars.

If commodities continue their fall, it would allow the Fed to maintain interest rates at their current level and allow more time for financial markets to recover.