Federal Reserve & Interest Rates

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.

The three major investment banks were all downgraded today by Standard & Poor’s and remain with a negative credit outlook as more write downs are expected.  Some experts are predicting over a $1 trillion in write downs for credit markets before it’s all said and done.

Today’s news has probably put an end to the speculation that the Fed will raise interest rates before the fall to combat high energy prices.  The Fed is quickly entering into a no win situation as fears of stagflation begin to take hold of the economy.

When a central bank has an uncomplicated recession to deal with, it can cut interest rates. When it faces a clear-cut case of inflation, it can raise them. The worst nightmare of any central banker – especially one with a tradition of political independence to defend – is stagflation, when raising interest rates to curb inflation will provoke a recession or deepen one that has already begun…

The economy sags under the combined weight of house price falls, consumer confidence at a 25-year low, the credit crunch and a still widening financial sector squeeze. Nonetheless, soaring prices for oil and other commodities, not to mention the higher cost of imports thanks to a devalued dollar, are pushing up inflation and (especially) expectations of inflation.

With the housing slump far from over it is a real possibility that the credit crisis could last well into next year.  As long as home prices keep falling, all mortgage related assets will be at risk from defaults and foreclosures despite the Fed’s attempts to prop up the banking system.

Treasury yields fell to their lowest level since March when investors were coping with the Bear Stearns collapse.  As investors shed risk and take shelter in Treasuries, the flight to quality is also mirrored in the general banking system.

Right now financial institutions don’t trust anyone except the Fed.  They definitely don’t want to lend to each other and only to individuals with the highest credit ratings and because of this mortgage rates are creeping up again.  With the mortgage market in disarray, any possibility of a housing recovery seems farfetched at the moment.