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.

Ahead of next week’s Federal Reserve on meeting on Tuesday and Wednesday, markets seem convinced that another 25 basis point reduction in the fed funds rate is likely. But whether it’s necessary is whole different matter.

Since the Fed embarked on its latest easing cycle in September of last year, it has cut the fed funds rate from 5.25% to 2.25% - ostensibly to defend against further deterioration in the economy due to the fallout from the credit crunch. But now, as the risk of higher inflation becomes more and more pronounced, there is reason to question whether a seventh cut in eight months would make much difference.

The first argument in favor of a pause in the easing cycle rests squarely with inflation. The recent inflation data from the Bureau of Labor statistics (plotted below on a year-over-year basis) has not been encouraging. Year-over-year inflation in the U.S. is now hovering around 4% - about twice the comfort level for most investors. Netting out food and energy costs (the red trendline), it’s clear that it is the commodities boom and concern about food prices that’s adding on the extra 1.5-2.0% to the inflation rate (see below). And considering that food and energy collectively hold a 25% weight in the CPI, what we’re seeing is one-fourth of the index driving about half of its year-over-year growth. But that has an impact on the rest of the index as well since consumers can’t very easily cut down on food and energy spending, meaning that everything else effectively occupies a higher percentage of their income post-food and energy. Point being: regardless of the gap between universal (blue) and core (red) CPI, inflation has been gaining strength in the economy, and is likely to do so unless some part of the equation changes.

(Note: if you’d like to play around with the inflation rate and come to your own conclusions, I can recommend no better source than the Federal Reserve Bank of Cleveland’s U.S. inflation page).

One potent part of the equation is, of course, the level of interest rates since more money in the economy made available by cheaper cost of capital means more inflation. Now, banks’ unwillingness to lend in the wake of the collapse of the credit markets last year, a lowering of interest rates was in many ways a necessary and appropriate policy step on the part of the Fed. But keep in mind that there is usually a 9-18 month lag from the moment that there is a shift in fed policy to when the real economy starts to respond. So, the argument goes, why not wait and see whether the medicine (combined with all the other credit crunch solutions the fed has rolled out) is working before you apply more of it, especially if it means risking stoking the fires of inflation which we already see lighting up.

The counter-argument is, of course, that we’re currently staring into the abyss of a recession - if we’re not already in one - and so it would be wise to have additional insurance against the downside risk of a recession, even if it means risking higher inflation in the short term. If credit conditions continue to worsen and consumer confidence weakens, spending and investment could continue to decline, leading to higher unemployment and an even-worse recession scenario (for a fantastic summary of this whole issue, see Greg Ip of the Wall Street Journal discuss his article on this subject in the video below). That leaves the fed in the difficult spot of having to choose between the potential for higher inflation or higher unemployment - the classic dilemma of fed policymaking.

So what’s the tiebreaker?

Legitimate concerns about inflation and unemployment aside, it is time that we start to consider another, less orthodox argument in favor of raising interest rates: the fed funds rate just isn’t the center of attention that it used to be. In today’s globalized economy, interest rates abroad and the actions of foreign investors have a much stronger impact on the strength of our economy than they used to. One potent example of this is the prevalent use of the London interbank offered rate, or Libor) as a benchmark interest rate in much of U.S. lending and - just as importantly - credit default swaps (CDS), which have become an increasingly popular financial instrument for managing and transferring the risk of default to someone more willing to accept it - obviously, for a price. I recently asked a friend of mine who deals credit default swaps what the first indicator he looks at in the morning is, expecting him to say something along the lines of the 10-year treasury or some other U.S. interest rate benchmark. Not so: it’s the spread between Libor and U.S. interest rates - just another example of how important this rate has become.

But the spread between U.S. interest rates and foreign rates is particularly important in an easing cycle because if trillions of U.S. corporate debt and mortgage loans are tied to a foreign rate on dollars like Libor, and foreign rates are higher, then lowering our interest rates simply doesn’t make as much of a difference as we would like it to. A clear indication of this is the fact that the average rates submitted by U.S. banks vs. European banks to calculate the Libor formula have consistently been lower since about the middle of the month, as reported by the Wall Street Journal this week. As a result, some are calling for the creation of a “NYbor,” or a Libor formula that reflects the borrowing costs of U.S. banks only, since it’s clear that U.S. borrowers are currently paying higher rates that exist on the other side of the pond.

Hence, it’s right to ask whether lowering the fed funds rate target is likely to make that much of a difference in this interconnected global environment, especially since interest rates at most other major central banks currently set higher (see table below or complete world interest rate data here). That spells further devaluation of the dollar against the Euro, the Pound and currencies of other major world economies if we continue to cut our interest rates relative to theirs. Sure, that may aid exports, but it is also likely to add even more inflationary pressure to the economy due to higher costs from imports.

Martin Feldstein, chairman of the Council of Economic Advisers under President Reagan, comes to the same conclusion using a different argument. In a recent editorial in the Wall Street Journal, “Enough With the Interest Rate Cuts.” Feldstein argues that cutting the interest rate won’t make as much of a difference as we’d like it to in stimulating our economy since “in previous recessions, lower rates stimulated aggregate demand by inducing increased home building. But with the massive inventory of unsold homes – up 50% from a few years ago – a further cut in the fed funds rate would have little effect on housing construction.”

So whether you look at it from the domestic standpoint or more globally, a cut in the fed funds rate at this point doesn’t carry as much upside as it does potential risks. Small surprise, then, that ahead of next week’s fed meeting, there isn’t as much excitement about the prospect of a rate cut as there is nervousness. Perhaps giving interest rate cuts a breather, then, is not such a bad idea.