The Fed’s In A Tough Spot

The Federal Reserve voted today to leave its federal funds rate steady at 2%.  In addition, in its statement, the Fed gave no real indication of which way rates will go in the future because I’m sure they really don’t know at this point what’s the greater risk … runaway inflation or a severe recession?  Inflation hawks, including Dallas Fed President Richard Fisher, want the Fed to preemptively raise rates to cut off any chance of inflation.  Others feel that by raising rates too soon, any nascent recovery in the credit markets, as well as the broad economy, might be stifled and that leaving rates at current, historically low levels is the prudent course.

It seems at this juncture that with the exception of Mr. Fisher, who cast the lone dissenting vote, the Fed feels that the risks are equally balanced between inflation and recession and that, over time, one clear economic theme will most likely predominate.

If there’s one job I would NOT WANT in this world right now, no matter how much money you offered me, its the head of the Federal Reserve.  Mr. Bernanke and his fellow Fed board members are in a truly tough spot.

Over the last two weeks, we’ve seen some signs that inflation is moderating as the world economy slows.  Oil has come off its all-time high, as have other commodities like corn and copper, in response to what is clearly a slowing world economy.  If those trends continue, in the ensuing weeks that should translate into lower costs for gas, food and other goods as lower fuel and input costs work their way through the system.

While cooling commodity prices are encouraging, the Fed can’t become too complacent.  If they keep rates low for too long real inflation could take root and we’d have a repeat of the 1970’s ‘stagflation’.  It’s a case of ‘damned if you do and damned if you don’t.’

It’s becoming increasing obvious that any economic recovery won’t happen in 2008 and may not happen until mid-to-late 2009 the Fed is taking a prudent course until there is enough evidence one way or the other how to proceed.

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Is Inflation Moderating?

The Labor Department earlier this morning reported that consumer prices rose .2% in April and a total of 2.3% year-over-year, a much tamer figure than most experts were expecting and much less than most people would think, given the high price of food, gas and other items.  That’s good news for those that thought we might be in the beginning stages of “stagflation” where we’ve got stagnant growth and high inflation, much as we say in the 1970’s.

The thing to remember about the consumer price number is that it’s reflective of all the goods and services sold in the economy.  The .2% number included a .9% rise in food costs and a 5.6% rise in gasoline but a reduction in the price of automobiles and lodging costs (hotels) as the demand for those items has dropped due to the higher cost of food and gas, among other things.  Gasoline prices ALWAYS rise this time of year in anticipation of the summer driving season and generally fall as the summer progresses.

The Fed has attempted to the delicate balancing act of cutting interest rates to keep the economy from falling into recession while at the same time not igniting excessive inflation and only time will tell if this month’s inflation reading was merely a statistical blip or if they’ve actually managed to pull it off.

Federal Reserve Trying to Hold Off Recession

The Federal Reserve today, in an attempt to improve conditions in the credit markets and, hopefully, help the economy avoid recession, opened its coffers and made $200 Billion (with a ‘B’) of highly-liquid U.S. Treasuries available to primary dealers, secured for 28 days. It also significantly expanded the types of securities that can be used as collateral for loans, allowing them to swap mortgage notes it can’t sell for government securities that can easily be sold to raise cash.

The hope from the Fed is that this action will bring some normalcy to a credit market that has all but dried up in recent months and that this cash infusion will allow banks to lend money to keep the economy moving.

The financial markets have responded well to this latest move, with the Dow, NASDAQ and S&P all up more than 3.5% today.

The other positive aspect of this move is that, unlike a broad interest rate cut, this strategic bump helps a specific portion of the market without stoking the fear of increased inflation.

Finally, to its credit, the Fed is being pro-active in addressing issues caused by the sub-prime meltdown and is using every tool in its arsenal to both (hopefully) contain and minimize the long-term impact.

Stay tuned to see how this plays out.