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.

Barely a week after last week’s extraordinary 75 basis point cut, the FOMC will meet again today to discuss whether or not to cut the Fed Funds rate.

Since the credit markets tanked in August of last year, we’ve had a 50 basis point cut in September, followed by 25 in October and another 25 in December at regularly scheduled FOMC meetings. Factor in the surprise 75 basis point inter-meeting cut, and that gets us to 175 bps of easing in less than five months.

Sounds familiar?

This pattern of drastic easing is very reminiscent of 2001 when the Fed, again reacting to extreme circumstances, drastically reduced interest rates in swift 50-basis steps (including an inter-meeting rate cut immediately folliwng the terrorist attacks of 9/11) to a floor of 1.00%. In total, the Fed Funds rate fell by 475 basis points, from a high of 6% in January 2001 to 1.25% in November 2002 - by which time our mid, short 2-quarter recession was long over - and then even lower to 1.00% in June 2003.

(FYI: a full history, 1971 to present, is compiled by the New York Fed and is available here).

Sure, hindsight’s always 20/20, but to me, that always seemed like a *bit* of an over-reaction, and as hindsight is quick to suggest, keeping such a low floor on interest rates for such a long time - they didn’t raise from 1.00% until their June 2004 meeting - certainly helped fuel the onslaught of cheap credit and mispricing of risk for which we are paying the price today.

So if 2001 was any lesson, I hope the Fed doesn’t over-do the rate cuts this time as well. From the looks of it, the market is predicting another 50 basis cut today, with at least 25 considered a sure thing. I think we’ll get at least that much. And with the yield on the two-year tresuries in the 2-2.25% range, the market seems to assume another 75 bps of easing ahead. So like it or not, 2008 will likely be a year of easing monetary policy. I just hope that it doesn’t prove to be - like in 2001 - too much, too late.