25 Basis Points - Here's Why (The Fed's Take)

Thursday, June 29, 2006

The Fed has acted as described in yesterday's post, raising the Fed Funds rate in an unanimous vote a 17th time 25 basis points (bp) to 5.25%.
In its statement the FOMC said that the expected cooling of the economy has become more visible.
"Recent indicators suggest that economic growth is moderating from its quite strong pace earlier this year, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices."
Even more interesting is that the FOMC takes note of spiralling commodities prices. Until now inflationary effects were mainly blamed on energy.
"Readings on core inflation have been elevated in recent months. Ongoing productivity gains have held down the rise in unit labor costs, and inflation expectations remain contained. However, the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures."
The FOMC hopes to benefit from slowing aggregate demand but pointed to remaining inflationary risks.
"Although the moderation in the growth of aggregate demand should help to limit inflation pressures over time, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. In any event, the Committee will respond to changes in economic prospects as needed to support the attainment of its objectives."
Restless markets took this statement as rather dovish in comparison to the May 10 statement, a stance I am definitely not willing to share.
Neither the Fed's pointing to inflation risks in both CPI and "core" inflation nor the phrase "inflation expectations remain contained" let me see a pause in August or later, save for a financial crisis. Real interest rates are still way too low to act as proper cushion for future inflation. Central banks everywhere may stick with questionable CPI data but human investors all tell a very different story of prices; worldwide.
I raise my end-year forecast of a Fed Funds rate from between 5.25% and 5.75% to 6% and more. International investors may become worried about the additional risk factor of slowing growth in the USA, now that the Fed too acknowledges that the housing market is past its top.
It will also depend on the ECB which has to catch up with true inflation too. Once the ECB decides a 50 bp hike, which could be as early as July 6th, interest rates will act as strong determinant for the "attractiveness" of the two currencies.
The ECB fights on 2 fronts. Today's release of money supply M3 growth in May shows an acceleration to 8.9% (April 8.7%), putting more pressure on the Eurobankers. The target rate of 4.5% M3 growth has been exceeded since the introduction of the Euro.
The other risks for the stability of the greenback remain unchanged: deficts, debts, this president.
The rally on Wall Street in the aftermath of the FOMC's decision will be shortlived as all the old problems are still around and will not go away. The strong run-up in precious metals and crude with Wall Street being in congruent mode is an anomaly that will soon correct itself.


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