Cezary Salad

As expected, the Fed today decided to keep interest rates unchanged for the first time since last September. The FOMC’s policymaking statement, reproduced below, signaled rising worries about inflation, mixed with some discussion on rising energy and commodity prices:

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.

Recent information indicates that overall economic activity continues to expand, partly reflecting some firming in household spending. However, labor markets have softened further and financial markets remain under considerable stress. Tight credit conditions, the ongoing housing contraction, and the rise in energy prices are likely to weigh on economic growth over the next few quarters.

The Committee expects inflation to moderate later this year and next year. However, in light of the continued increases in the prices of energy and some other commodities and the elevated state of some indicators of inflation expectations, uncertainty about the inflation outlook remains high.

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time. Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Voting against was Richard W. Fisher, who preferred an increase in the target for the federal funds rate at this meeting.

It is noteworthy that Fed’s language on inflation has essentially remained unchanged. For the fifth straight time this year, the Fed mentioned that it “expects inflation to moderate” in the coming months/quarters and warned that uncertainty about inflation remains high.

This was a bit surprising since many economists had expected the Fed to sound more hawkish about inflation. In October of last year, when the Fed decided to cut the target federal funds rate by 25 basis points to 4.25%, it stated that “after this action, the upside risks to inflation roughly balance the downside risks to growth.” The interest rate cuts in the months since then imply that deteriorating economic growth threw this balance out of whack and the Fed has focused more on the growth downside than the inflation upside, noting with each cut that it expects inflation to moderate in the coming quarters. But now, with consumer price inflation near 4%, wholesale price inflation at 7% and consumers’ one-year inflation expectations north of 5%, seeing the same language on inflation was indeed a bit of a surprise.

Consider also that Fed’s view of the pace of economic expansion has brightened considerably. In January, March and April, the FOMC cited weakness in the economic activity or outlook; this time, it opined that “economic activity continues to expand.” Conventional wisdom would imply that if the economic outlook is finally brightening, then the Fed should take a more hawkish stand on inflation. So again, it seems like the Fed is not yet in panic mode about inflation. Rather, it seems that the Fed’s decision to halt its easing cycle had more to do with the brightening economic outlook than anything else.

Commodities and energy prices also made a repeat appearance in the FOMC statement, with their third mention in three meetings, but with one significant difference: in March and April the Fed cited a “leveling-out of commodity and energy prices” as a factor in its view that inflation will moderate in the near term. This time, instead of leveling-out, it cited continuing increases in the prices of energy and commodities. As I argued yesterday, a statement along these lines would seem to imply tightening of monetary policy sooner rather than later since interest rates and commodities prices are inversely related. Higher real interest rates would reduce demand for commodities - both from physical hedgers, who would face a higher cost of storing commodities and speculators, who could begin to see higher returns on their capital in other asset classes - and thus ease some of the upward pressure on commodity prices.

[For a nifty overview of the impact of monetary policy on commodities prices, click here]

Not surprisingly, after the FOMC’s announcement Forbes reported that August Fed Funds futures moved lower, implying a higher probability that the Fed will raise the target for the Federal Funds rate in August by 25 bps - up to 43% from 41% yesterday.

Given this statement, as well as Dallas Fed Governor Richard Fisher’s dissenting vote, this expectation seems reasonable. But it also begs the question: are we now, in the Fed policymakers minds, back in the same spot as October, with the upside risks for inflation and the downside risks for the economy roughly in balance, or does the heightened caution on commodity and energy prices provide a subtle hint that the balance will finally shift toward inflation upside?

To use the Fed’s parlance, this remains to be seen, and will be monitored closely.

Yesterday most major U.S. stock indexes finished the day either flat or slightly lower as markets await with anticipation to see what action the Fed will take at the end of its two-day policymaking meeting that starts today.

It’s a sort of nervous quiet-before-the-storm that comes whenever the markets anticipate a change in direction in Fed policymaking. But this is not just a drizzle; investors are curious to learn how what the Fed’s next step will be in tackling what seems to be the perfect storm of sky-rocketing commodities costs, soaring inflation and a plummeting dollar.

After nine months and 325 basis points of easing, fed funds futures are overwhelmingly pointing to a halt in easing - to be exact, an 87% probability (as of June 20th) that the FOMC will leave the Federal Funds Rate target unchanged, as calculated by the Cleveland Fed.

This comes as no surprise since most economic indicators still point to an uncomfortable netherworld between contraction and expansion that seems to call for a pause and rethink of where the economy is going. The index of Leading Economic Indicators (LEI) - a composite of a group of 10 macroeconomic statistics that are known to change in advance of a contraction or expansion - despite moving higher by a slight .1% last month, gave us little insight since six of the ten components moved down and October through February marked a period of -1.8% contraction in the LEI that fell just shy of predicting a recession (according to the rule of thumb of 2% decline in the index over six months and a majority of components moving lower).

No matter what it decides to do, the Fed will likely highlight this uncomfortable netherworld situation in its statement on Wednesday, warning us of the continuing downside risk and the need to monitor the inflation situation closely.

Important as this may be, though, the real words to watch for in its statement - given recent statements by Treasury Secretary Paulson and Fed Chair Ben Bernanke - will be the dollar and commodities, both of which have been enjoying increasing popularity on Capitol Hill and the campaign trail lately, and for obvious reasons.

Since Mr. Bernanke has taken over as the chairman of the Fed, the dollar has depreciated in value against most of the world’s major currencies (this clever graphic from the Telegraph says it all) - a decline that has only thrown more fuel on flame-hot commodity prices, which have become increasingly correlated with the depreciating dollar over the last year. This should come as no surprise: after all, with credit markets frozen and falling interest rates at home, where were investors to park their money except foreign currencies and a booming commodities market?

Still, as anyone who regularly reads the FOMC’s carefully-crafted and blandly worded policy statements knows, the Fed is unlikely to make a big splash about commodities and the dollar. Nonetheless, investors are curious to know whether all the talk of bolstering the dollar and reigning-in commodities prices really has any policy teeth behind it - which is why the reason behind the Fed’s staying the course, if it does so, will be particularly illuminating.

If it cites the threat of inflation as its primary policymaking motivation, then the case could be made for a prolonged wait-and-see approach since inflation is a lagging economic indicator. On the other hand, if it cites worries about the plummeting dollar and its impact on soaring commodities prices, then there is a strong argument to be made that there is little time to waste since both are already at historic lows and highs, respectively. As a result, the Fed will be expected to raise rates sooner rather than later, (in which case expect to see the implied probability of a 25 bps increase in August edge higher than the current ~20%).

But whether it’s soaring commodity prices, inflation, or a plummeting dollar, at the root of each - as well as their after-shocks in the over-heated housing markets - lies the 2001-2004 Fed easing cycle carried too far and too long. This is why some economists, including Dr. Benn Steil, Director of the International Economics Council on Foreign Relations, have wisely begun to point out that we are currently experiencing not so much the beginning of (yet!) another bubble, this time in commodities, but rather the aftermath of a previous, much larger currency bubble. As Steil testified two weeks ago in front of the Senate Committee on Homeland Security and Governmental Affairs, “the Federal Reserve pushed rates too low and held them too low for too long, and has since last autumn been exceptionally aggressive in driving them well below the rate of inflation.”

The “since last autumn” part is, of course, how we got to this spot in the first place, and doing so again will only continue to widen the yield gap between the United States and the rest of the world, including oil-rich states like Saudi Arabia, which last year for the first time refused to lower its interest rates in lock-step with the U.S. Federal Reserve.

A telling sign of the times? Certainly; but more so a reminder not to repeat the mistakes of the past - even in the face of the perfect storm.