Fed Rate Increase Looking Less Likely

How little resolve our central bank has. We said we thought Fed was unlikely to raise rates, or if it did, it would be at most 25 basis points between now and year end., which falls in the category of being cosmetic. The central bank has been particularly, one might say unduly, attentive to the health of banks. Despite a good deal of cheery chat that the credit crisis is on the mend, the housing market has not bottomed, and corporate and consumer defaults are on the rise.

However, as some alert readers noted, the markets chose to read Bernanke’s statement as more hawkish than it was. While it did acknowledge concerns about the dollar, it also mentioned risks to growth. Thus the Journal story, “Fed Mood Tilts Away From Rate Increase” may overstate the degree of change in Fed posture.

From the Journal:

The Federal Reserve is almost certain to leave interest rates unchanged when it meets next week, and it currently doesn’t appear to see a compelling case for raising rates before the fall…An August rate hike can’t be ruled out…

But for now, Fed officials want to both demonstrate their vigilance against inflation risks, particularly from soaring energy prices and the weak dollar, while also giving the economy time to recover from the trouble in the housing, labor and financial markets.

As a result, the Fed’s policy statement following its meeting next Tuesday and Wednesday is likely to use stronger language about the risks from inflation than in May, but is unlikely to go so far as to ratify market expectations of a rate hike as soon as August….

In recent days, markets have seized on comments made last week by Fed Chairman Ben Bernanke that suggested a greater focus on inflation concerns, and particularly on the public’s expectations of a rise in inflation. “The latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations,” he said in a speech on June 9. He said that the Fed “will strongly resist” allowing inflation expectations to get out of hand…..

But Mr. Bernanke also said in his speech that the housing contraction and energy-price surges “suggest that growth risks remain to the downside,” even though the risk that the economy “has entered a substantial downturn” had fallen.

There is so far little evidence that either underlying inflation or the public’s long-term inflation expectations have reached a danger point. Mr. Bernanke and most other officials believe inflation expectations remain under control. The pace of inflation, excluding volatile energy and food prices, has remained near the top of the Fed’s preferred range of 1.5% to 2%, based on its preferred price index. And with the economy weak, workers are unable to win wage gains in a way that would send inflation spiraling higher. The latest data show wage gains actually slowing — the opposite of what has occurred in Europe, where rising wages are triggering tough anti-inflation rhetoric from the European Central Bank.

What’s more, Mr. Bernanke and other Fed officials believe financial markets remain especially fragile. Raising rates soon could worsen those troubles, hitting the mortgage sector and lengthening the housing downturn.

“The outlook for the financial crisis would worsen,” said Tom Gallagher, an analyst at brokerage ISI Group. The Fed usually doesn’t stop easing rates until the unemployment rate peaks, Mr. Gallagher notes, and a peak in jobless figures hasn’t necessarily happened yet. If rate hikes were to start soon, “the Fed would be tightening well in advance of the traditional indicators.”…

Several presidents of regional Fed banks have expressed strong concerns in recent months about the inflation outlook. That could lead to more dissent at the upcoming meeting, continuing a string of minority opposition since last fall.

Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, said in a speech Monday that the Fed should be prepared to raise rates as the risks of weaker growth diminish. But Mr. Lacker, who is generally hawkish on inflation, also suggested a willingness to hold rates steady for now, by noting that inflation expectations haven’t gone “adrift.”

“We seem to have dodged this risk so far,” Mr. Lacker said. “Inflation expectations are higher than I would like, but are relatively stable.”

Note that other observers are coming to the same view, including Bill Fleckenstein at MSN and Ed McKelvey at Goldman. But I particularly like how John Dizard makes his case:

Dr Egon Spengler: “There’s something very important I forgot to tell you.”

Dr Peter Venkman: “What?”

Dr Spengler: “Don’t cross the streams.”

Dr Venkman: “Why?”

Dr Spengler: “It would be bad.”

Dr Venkman: “I’m fuzzy on the whole good/bad thing. What do you mean, ‘bad’?”

Dr Spengler: “Try to imagine all life as you know it stopping instantaneously and every molecule in your body exploding at the speed of light.”

Dr Ray Stantz: “Total protonic reversal.”

Dr Venkman: “Right. That’s bad. Okay. All right. Important safety tip. Thanks, Egon.”

( Ghostbusters , 1984)

Ben Bernanke and Jean-Claude Trichet have nearly crossed some “streams” of their own in the past couple of weeks, much like Bill Murray’s disreputable “scientist”, Dr Venkman. This has had results for, among others, Lehman Brothers’ shareholders and management, close to “total protonic reversal”.

The central bankers’ streams are two mutually exclusive policies: the containment of inflation and the avoidance of systemic risk to the financial system. The official pretence, now hard to maintain, is that, thanks to clever management, there is no contradiction between the two; that careful balancing of priorities can ensure stable currencies and the continued support of a highly leveraged financial system.


Just as capital is being withdrawn from speculative trades, there are more possibilities emerging for speculation all the time, thanks to the internal contradictions of central banking. The time for principled stands by Federal Reserve governors against official support for over-leveraging came and went years ago, starting in 1998. It’s really too late for that now. Time was bought, for politicians, policy people and the investment world. Now it will be paid for.

The question is whether it will be paid for with devalued currency or with cans of preserved food and AK-47 ammunition. The answer is devalued currency. No, Lehman – or the next name – will not be allowed to collapse. To avoid that, though, policy will need to remain accommodative, as they say.

So, contrary to what is now being priced in, I do not think the Federal Reserve will raise the policy rates just before the presidential election. The European Central Bank may have more nerve, but its board may run into political roadblocks to tightening, whatever the governing treaty says.

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  1. Anonymous

    I’m surprised at how naive they are. They really have no idea what civil unrest looks like.

  2. Hubert

    There is nothing in the WSJ story that tracks directly to the Fed. Lacker´s quote is slightly ambiguous as usual. The Fed´s “mood” – please! How did they find out about the Fed´s mood?

    Alone the fact that the WSJ put this journalistic compositionon Page 1 and the fact that Eurodollars went up big yesterday afternoon indicate that something important is brewing – if it´s not planted by an underwater IB prop-desk.

    I would asign a 75% probability that the Fed is really behind this article – paradoxically as no finger-“print” can be found.

    Who is more familiar with the inner workings of the Fed/WSJ and may speculate about the making of this journalistic masterpiece ?

  3. Yves Smith


    I had the same line of thought, but normally they use Greg Ip for those “from the Fed’s mouth to the Journal’s pages” communiques. The author here is Sudeep Reddy, so it’s less clearly a plant. But you are right, otherwise it has the earmarks.

  4. trotsky

    it should have been clear from the outset – rescuing the members of the moribund banking cartel is clearly higher on the list of central bank priorities than their fake ‘fight against inflation’. central banks exist in order to inflate – it is their very raison d’etre. to suggest that they ‘fight inflation’ is a contradiction of terms; what they like to do is inflate as much as possible without anyone noticing, i.e., while ‘managing inflation expectations’. now that the lagged effects of decades of monetary inflation are beginning to percolate through the economy, spilling from financial assets into commodities, people are beginning to notice that inflation is a deliberate policy – thus all the ‘hawkish talk’ of late. the genie however seems to have left the bottle.

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