Inflation Concerns Keep Fed On Measured Path

Tuesday, September 20, 2005

With the added impact of hurricane Katrina amidst slowing economic indicators and rising unemployment the Federal Open Market Committee's (FOMC) job to keep the economy in balance has become a lot trickier. While the FOMC acted as anticipated and raised the Fed Funds rate the 11th time in a row to 3.75 % and also kept the much discussed phrase about its "measured path" of removal of accommodative monetary policy in the statement, it can be read between the lines that inflationary pressures stemming from higher energy and other costs will keep the Fed rising rates for at least one more time.
Uncertainty about the near-term outlook was also reflected in the vote. For the first time since the Fed started rising rates it was not an unanimous vote. Fed governor Mark W. Olson voted for a pause at this FOMC meeting.
Worth noting is also the fact that the long-term inflation outlook appears now only "contained" to the FOMC. In previous statements this outlook had been described as "well contained."
What the most recent statement of the FOMC lacks is the confident and complacent tone of previous statements. Until today the Fed has appeared more knowledgeable about the future course of the economy. Admitting to uncertainty in the wake of Katrina can be seen as a straight way to be as honest as possible. But this will certainly not manage to instill confidence with the growing number of already very wary investors. See markets heading lower for the rest of the year.
While the Fed still tries to play down inflation fears by pointing at the relatively low core inflation rate the high priests of ever expanding credit nevertheless warned of higher energy and other costs. Well, if energy and other costs rise, what is remaining as the core inflation rate?
Being very critical of these so called "core" rates I want to remind readers that core inflation and the Consumer Price Index are actually two completely different things unless we learn to live without energy and nutrition. Inflation for mere mortals is now running at an annualized rate of 6.17 percent.
It is also to be seen whether the Fed will finally tighten money supply. The graph (click for larger image) shows that all 11 rate hikes have had close to zero effect in this matter. Money supply has rather accelerated in the past two years.
Market participants impulsively categorized the statement as one that rather raises more questions than it answers, an opinion I humbly share.
Markets immediately jumped on the Fed's bandwagon of uncertainty, sending both stocks and bonds lower while the dollar shot to its highs of the day. The surge in the dollar can be explained by the fact that investors will be able to achieve higher yields on their future investments in the debt market. This will work in the short- to medium-term only, see the post "There Is No Free Lunch - Higher Rates Equal Higher Risk."
Following the markets pointedly negative reaction the Fed for the first time in a while has failed to calm investors who anyway face a long list of economic threats:
  • Current account deficit
  • Budget deficit
  • Trade deficit
  • Inflation
  • Medicare
  • Current (Iraq) and looming wars (Iran)
  • GSE's (includes the housing bubble)
  • Stagnant private sector employment
  • Katrina's costs
  • The highway bill
  • Demographics
None of these issues has yet been adequately addressed by the current administration and the global growth outlook does not offer any relief either. The booming economies in the Far East will come to a sudden standstill as soon as growth projections for the US get revised downwards again. The Fed itself has raised this possibility, saying that Katrina will dent the near-term outlook.
But then it is to be remembered that Katrina is not the single issue wreaking havoc on the American economy. It should rather be called the drop that led to an overflowing barrel. See the list above.

Comparison Of The Two Latest Statements
September 20: The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 3-3/4 percent.
August 9: The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 3-1/2 percent.
September 20: Output appeared poised to continue growing at a good pace before the tragic toll of Hurricane Katrina. The widespread devastation in the Gulf region, the associated dislocation of economic activity, and the boost to energy prices imply that spending, production, and employment will be set back in the near term. In addition to elevating premiums for some energy products, the disruption to the production and refining infrastructure may add to energy price volatility.
While these unfortunate developments have increased uncertainty about near-term economic performance, it is the Committee's view that they do not pose a more persistent threat. Rather, monetary policy accommodation, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. Higher energy and other costs have the potential to add to inflation pressures. However, core inflation has been relatively low in recent months and longer-term inflation expectations remain contained.
August 9: The Committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. Aggregate spending, despite high energy prices, appears to have strengthened since late winter, and labor market conditions continue to improve gradually. Core inflation has been relatively low in recent months and longer-term inflation expectations remain well contained, but pressures on inflation have stayed elevated.
UNCHANGED: The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.
Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.

September 20: Voting for the FOMC monetary policy action were: Alan Greenspan, Chairman; Timothy F. Geithner, Vice Chairman; Susan S. Bies; Roger W. Ferguson, Jr.; Richard W. Fisher; Donald L. Kohn; Michael H. Moskow; Anthony M. Santomero; and Gary H. Stern. Voting against was Mark W. Olson, who preferred no change in the federal funds rate target at this meeting.
August 9: Voting for the FOMC monetary policy action were: Alan Greenspan, Chairman; Timothy F. Geithner, Vice Chairman; Susan S. Bies; Roger W. Ferguson, Jr.; Richard W. Fisher; Donald L. Kohn; Michael H. Moskow; Mark W. Olson; Anthony M. Santomero; and Gary H. Stern.
September 20: In a related action, the Board of Governors unanimously approved a 25-basis-point increase in the discount rate to 4-3/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Richmond, Chicago, Minneapolis, and Kansas City.
August 9: In a related action, the Board of Governors unanimously approved a 25-basis-point increase in the discount rate to 4-1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco.

It will be most interesting to scrutinize the FOMC minutes in 3 weeks from now.

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