No Interest Rate Cuts? FOMC's Double Edge Sword

During the last few months we have been discussing the risks associated with inflationary pressures and the current levels of the stock market. One of our articles titled "Where's the Inflation? Check the Non-Core Components of the PPI and CPI" pinpointed inflationary pressures in food and energy that seemed to go unnoticed a couple quarters ago. Now, as risks increase in equity-based investments, the Federal Reserve is starting to pay attention to the inflation that exists in non-core components of the producer Price Index and the Consumer Price Index respectively.

This reevaluation of inflationary pressures away from the core rate of inflation is ill-timed. This is ill-timed because the market is under pressure and additional pressures from the Federal Reserve could easily compound the equity risks that exist at this time. The article that we wrote a few months ago suggested that the Fed should pay close attention to food and energy prices, but timing is everything.

Now the market is faced with a double edged sword. The stock market expects the Federal Reserve to cut interest rates. Excerpts from CNBC suggest that there is a 119% chance that the Fed will cut interest rates in December and probably January based on the stock market's expectations. However, chairman Bernake and other governing board members of the FOMC emphasize that inflationary pressures are high given food and energy prices and the associated weak dollar.

The odds that the Federal Reserve will cut interest rates again in the near term are diminishing, yet Wall Street believes that Bernake will continue to pay attention to the desires of the street. We have in the past emphasized that this is a big mistake. Wall Street wants the Fed to take action so that they can make money today. Wall Street is not as concerned with longer-term economic conditions as they are with making a quick buck. Sure, making money is an objective of everyone, but at the expense of economic controls? We should also be willing to wait.

Unfortunately, if the Fed does not cut interest rates in December the stock market is going to react negatively. I do not expect the Federal Reserve to cut interest rates again soon. However, I do expect economic conditions to worsen. The double edge sword is that the FOMC no longer has the ability to cut interest rates in the late face of inflation, but it needs to because the economy needs it.

The landscape could not be worse Our economy is weakening and likely to weaken quite a bit more, yet the Federal Reserve is handcuffed due to inflationary pressures. If Bernake decides to cut interest rates he will completely ignore the inflation that exists in the economy. However, if he doesn't Wall Street will think that he's ignoring them. This is a no-win situation.

The potential losers in this race will be companies which are closely tied to interest rates as they pertain to current economic conditions. Companies like Bank of America (BAC), Washington Mutual (WM), Countrywide Financial (CFC), and other mortgage related stocks are obviously at risk. If the FOMC fails to cut interest rates, which we expect they will forgo, these stocks will be hurt. In addition, interest rate sensitive stocks like Altria Group (MO) and Fannie Mae (FNM) will also be adversely affected.