The Fed & Interest Rates

In the last few trading days, expectations about Federal Reserve policy have changed drastically. When the Fed cut its target rate to 2%, Bernanke mentioned that the risks to inflation and growth were about equal. Most people took his comments as meaning that there would be no more rate cuts and rates would remain at 2% for some time (at least until the health of the economy looked a little more promising).

On Friday, the European Central Bank (ECB) President Jean-Claude Trichet made a statement hinting that the ECB will be raising rates at its next meeting. This news, coupled with the poor employment number, equaled trouble for the dollar at the end of last week. However, over the weekend Bernanke and his colleagues at the Federal Reserve stepped in and made comments that supported the dollar. Bernanke also hinted that rates could go higher to combat inflationary pressures. In a matter of three days, the dollar went from free-fall to near bull mode. All the interest rate futures are now pricing in multiple rate hikes by the end of the year. The Fed is expected to keep its target rate at 2% at its meeting later this month, but by the end of the year traders are betting on a 75 basis point increase. In my view, I think the traders are getting ahead of themselves.

As of right now, the Fed needs to keep its target rate at 2% for the following reasons:

1) Five consecutive months of contraction in the job market. The only statistic that remains strong is the initial jobless claims number which is holding steady and still above typical recessionary levels.

2) Continued weakness in the housing market. Mortgage rates are resetting and if the Fed raises rates, the delinquency rate on sub-prime loans will surely increase.

3) GDP at a standstill and a struggling consumer. With record commodity prices, the consumer has begun to shift its spending habits and many businesses are expected to slow because of this adjustment.

4) A broken financial system. When the Fed cuts rates (and the yield curve becomes steeper) banks can make more money in their lending businesses. However, if the Fed raises rates, the fragile banks will face another unneeded headwind.

5) Finally, in my opinion, if the Fed raises rates 75 basis points by the end of the year (which is very wishful thinking barring no extraordinary events) it will just look bad. What’s the point of raising rates when we just finished lowering them 325 basis points? Typically, everyone says rate cuts take about 9 months to take effect so the economy is just beginning to feel these rates cuts. It is too early for the Fed to tighten its monetary policy.

The market has been extremely choppy and volatile of late, mostly due to uncertainty about the economy, surging energy prices, continued weakness in the housing market, and renewed concerns among the financials.