Federal Reserve & Interest Rates

Yields on Treasury Securities with maturities of between one and five years have climbed at least half a percent since the start of the month as investors have begun fleeing the safety of government fixed income securities despite the fact the economy continues to worsen.  Investor flocked to Treasuries in earnest back in March in the wake of the Bear Stearns collapse but now inflation concerns have overridden fears about a recession.

It seems that Wall Street isn’t buying into the Fed’s reassurances that it is committed to combating rising inflation expectations and right now they have about as much creditability as the administration does in it’s commitment to the “strong” dollar policy.  The steepening yield curve is actually beneficial to the struggling financial services sector at the moment as it borrows short and lends long.

American consumers are also starting to feel the brunt as high energy prices are beginning to bleed into the general economy with core inflation starting to creep up the last couple of months.  The weak dollar as also had a significant effect as America’s insatiable appetite for imports has also become more expensive.

With the Fed looking to delay raising rates for as long as possible with the housing and financial markets still a major concern, inflation will most likely continue to grow for some time due to the lag effects of Fed policy actions.  It is unlikely they will take any action next week at their regularly scheduled meeting and most analysts aren’t expecting any kind of change at least until September.

Oil exporting countries have resisted calls to increase production, calling current prices unjustified based on supply and demand dynamics.  As investors have continued to flock to the commodities market as an inflation hedge, prices have risen in an ever growing bubble that many are calling for the Fed to burst in order to give some sort of relief from soaring energy prices. 

On Thursday, the Department of Labor released it’s report for the Consumer Price Index(CPI) which showed a large spike in commodity prices in May.  After energy prices remained stable in April, they rose sharply last month causing a 0.6% rise in the CPI, the largest since November.

The 4.4% rise in energy prices is becoming a major concern for many officials at the Fed, while Chairman Bernanke maintains that he believes inflation growth will slow due to the softening economy.  While core inflation remain relatively low at 0.2%, which was what economists were predicting, it is doubtful energy demand will decrease in the near future with the summer driving season now upon us.

Many analysts are predicting $150 a barrel price for oil before the summer is over.  The G-8 finance ministers are now calling rising energy prices the biggest threat to global economic growth, surpassing credit concerns which have plagued the world for the past year.

Many consumers are already worried about the high price of gas but it still has a ways to go before it matches the relative increase in the cost of oil, which has more than doubled in the past year.  It is becoming apparent that rising commodity prices are beginning to have a significant impact on the standard of living for many Americans.

The Fed would prefer to keep rates stable for as long as possible with signs that the housing market continues to worsen, which is causing growing losses in the financial sector.  If other central banks raise rates in the mean time to combat inflation, we could see energy prices climb even higher as the dollar takes another pounding.

Relief in energy prices is not expected to arrive until September when most investors are predicting the Fed will most likely raise rates.  With unemployment surging last month as well it is becoming increasingly difficult for the Fed to keep the economy out of a recession.

There is a growing pressure from some members of Federal Reserve Board to raise rates with the mounting threat of inflation due to high dollar denominated commodity prices, namely food and oil.  Fed Chairman Ben Bernanke has thus far resisted these efforts believing that the economic slowdown will help slow inflation growth.

Inflation has remained high, largely reflecting sharp increases in the prices of globally traded commodities.  Thus far, the pass-through of high raw materials costs to the prices of most other products and to domestic labor costs has been limited, in part because of softening domestic demand.  However, the continuation of this pattern is not guaranteed and future developments in this regard will bear close attention.

Moreover, the latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations.  The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation.

Thus far the numbers appear to confirm this with core inflation excluding food and energy rising slowly, however in April the Producer Price Index for finished goods showed an increase that was higher than what many economist were predicting.  Energy and food prices actually retreated somewhat that month before climbing again in May and June.

The Fed is in a difficult position, while inflation pressure continues to increase, unemployment has started to creep up.  There also remains quite a bit of instability in financial markets with more writedowns expected from the subprime fallout.

With inflation starting to become a concern in other economies of the world, a number of central banks are considering rate hikes themselves, which would put negative pressure on the dollar and raise commodity prices further.  As much as the Fed would like to keep rates at their current level until the housing market shows signs of improvement, many investors believe that the Fed will have to act soon, with futures trading pricing in a rate hike by September.