Fed Policymakers Look to Juggle Inflation, Stagnation

By , Money Morning •

By Jennifer Yousfi
Managing Editor

The U.S. Federal Reserve faces a tough challenge as it kicks off a two-day policymaking meeting tomorrow (Tuesday): It probably needs to start raising interest rates to prop up the U.S. dollar and offset a major escalation in inflationary pressures; but the economy needs low interest rates if it's to maintain its anemic growth rate.

After one of the Fed's most aggressive rate-cutting campaigns ever slashed short-term interest rates from 5.25% in mid-September to 2.0% now, experts now expect the central bank to reverse course. And this week's two-day meeting of the policymaking Federal Open Market Committee (FOMC) represents the first chance for the central bank to boost its benchmark Federal Funds rate.

Recent hawkish comments by central bank Chairman Ben S. Bernanke had led some analysts to expect a 25-basis point rate increase at this meeting, but front page stories in both The Wall Street Journal and The Financial Times are detailing softened expectations.

The odds of an increase have fallen: Fed Funds futures traded on the Chicago Board of Trade are pricing in a 10% chance of an increase in this overnight lending rate. Any announcement will likely be made at the conclusion of the FOMC meeting on Wednesday. Prior to the recent news stories, the odds were about 22%. Odds of a rate increase at the FOMC's August meeting also fell.

Investors also will be interested in the accompanying FOMC statement that will be released around 2:15 p.m. EDT on Wednesday.

The statement after the last FOMC meeting acknowledged inflation concerns, but maintained that economic growth was still the top priority. A more-balanced statement is expected this time around as commodity prices continue to soar and oil recently flirted with a new high of $140 per barrel.

Many analysts have called for interest rate increases to stem inflation and prop up a weak greenback, which only serves to fuel the increases in dollar-denominated commodities such as oil. The dollar dropped last week against all major currencies, according to Bloomberg data, falling to $1.562 against the euro on Friday.

"The re-emergence of financial concern places a question mark on the Fed's ability to raise interest rates," Matthew Strauss, a senior currency strategist in Toronto at RBC Capital Markets Inc., a unit of Canada's biggest bank Royal Bank of Canada (RY), told Bloomberg News.

Referring to the April 22 high of  $1.6019, Strauss said that "the possibility of a revisit to $1.60 is still in the cards."

Even if the volatile costs of food and fuel are excluded, the current consumer price index (CPI) is at 2.3%, above the Fed's 2.0% inflation target.

Recovery Far from Certain

Inflation has grabbed most of the recent headlines, but the weak economy continues to be a concern.

The U.S. economy continues to sputter along without a true contraction, but gross domestic product (GDP) growth has been far from robust at just 0.9% for the first quarter. The subprime mortgage crisis that first began around this time last year with the implosion of two Bear Stearns Cos. Inc. (BSC) hedge funds (whose managers were recently indicted), continues to take a toll on both the financial and housing industries.

Separate government reports recently showed that housing starts hit a 17-year low while the producer price index (PPI) jumped 1.4% in May.

"We will not likely see the next action, rate hikes, until late in this year at the earliest," Joel Naroff, president and chief economist at Naroff Economic Advisors, wrote in a note to clients. "The housing and industrial production data released [last week] do not tell us the economy has stabilized to the point where the Fed would have any cover to raise rates."

And if a recent report from analysts at the Royal Bank of Scotland Group PLC (ADR: RBS) is correct, an economic recovery remains in the distant future.

RBS analysts have warned clients to brace for a full-blown crash in the global stock-and-bond markets in the next three months, as the conflicting realities of slowing growth and rising inflation paralyze the world's major central banks - causing "all the chickens [to] come home to roost," Great Britain's Daily Telegraph newspaper reported.

The predicted swoon would cause the U.S. Standard & Poor's 500 Index - already down 16% from its trading high of 1,576.09 reached Oct. 11 - to nosedive all the way down to 1,050 by September. For the closely watched, broad-based U.S. stock index, that would represent an additional decline of 20% from Friday's close of 1,317.93- and a total decline of 33% from its Oct. 11 apex.

At the same time, lending standards remain tight and many sectors of the credit market are nearly frozen, despite the aggressive rate-cutting campaign by the Fed that has brought the key interest rate down to 2.00% from its high of 5.25% last September.

The spread between the London Interbank Offer Rate (LIBOR) and the Fed Funds rate remains wide, as the three-month LIBOR was at 2.80% on Friday, according to MarketWatch data. Banks are still gun shy about lending, as major houses continue to take multi-billion dollar write-downs on mortgage-backed securities and other high-risk assets.

As long as the LIBOR rate is so much above Fed Funds, the U.S. central bank will unlikely tighten, William O'Donnell, U.S. government bond strategist at UBS Securities (UBS), told MarketWatch.

"There are still credit issues out there and LIBOR is an unsecured rate," O'Donnell said. "Banks don't want to lend to each other when it's unsecured. Risks to growth are very high. Very clearly, the Fed is trapped in a vise." [For a related story on the U.S. Federal Reserve and recent economic developments, check out this related story in today's issue of Money Morning.]

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