Following Misguided Cuts, The Fed Is Trapped

The Dow was clobbered for 3.8% last week, and the S&P500 dropped 3.1%, as financial stocks again led the way lower. Both the Dow and the S&P 500 have returned to double-digit losses for 2008.  The combination of carnage in the banking sector and oil prices holding at levels 30% above prior inflation-adjusted peaks is proving to be too much for the broader stock market to withstand.

Another worry that has gripped financial markets in recent weeks is that central banks around the world, and particularly in the U.S. and emerging economies, will be forced to hike short-term interest rates to fight inflation. The Federal Reserve will have an opportunity this week to back up its more hawkish-sounding rhetoric with a rate increase at its scheduled FOMC meeting. Even though the Fed seems to have finally figured out that its aggressive easing actions since last summer have missed their target - by creating an energy price shock while doing little to prevent the fallout from the credit and housing bust - we will be surprised if the Fed decides to raise the Fed Funds rate this Wednesday. If the Fed surprises us and decides to hike by a quarter point, it would be merely a symbolic gesture designed to take some froth out of the energy markets, and would not represent the start of a significant tightening move. The economy, banking system and stock market are too weak for this easy-money Fed to tighten in any meaningful way.

The fact of the matter is that the Fed is trapped - caught between the worst commodity inflation since the 1970s and massive deflationary impulses emanating from the credit and housing bust, the banking sector crisis, and a weak stock market. The Fed's misguided decision to slash the Fed Funds rate from 5.25% to 2% has created serious price inflation, led by energy and food, which has dealt a crippling blow to consumers not just in the U.S. but abroad since many emerging economies tie their monetary policies to ours. In the U.S., inflation in essential commodities is reducing consumer discretionary incomes and the capacity to service enormous debt loads, at a time when household net worth is falling.  All of this is creating an extremely challenging investment environment where preservation of capital should continue to be the priority.

The greatest short-term problem facing the stock market is the price of oil.  There has been an obvious negative correlation between oil and stock prices since oil prices moved above $100/barrel. Although the fundamentals (i.e. a softer global economy and more hawkish global central bankers), combined with overextended oil prices, suggest that a correction in coming, the timing is impossible to gauge.  When speculative dynamics take hold in a market, the ultimate price peak can be far higher than anyone expects.  Geopolitical tensions in the Middle East introduce another unpredictable element. Given the underlying fragility of global stock markets, a further spike in oil prices would almost certainly inflict serious damage to stock prices.   Conversely, if oil prices were to turn lower, and financial stocks stabilize, the stock market may be able to right itself and avoid a retest of the March lows.

Comments

[gabe borens...:]

The greatest mistake that the FED would commit would be to raise the rates.Inflation is not an issue .Unprecedented commodity leveraged speculation is-that includes oil.In the true inflationary environment ,the real estate prices would be rising at the implied rate of inflation or faster.What exist in the housing industry is the greatest debacle since 1929 as the prices have imploded.In fact the higher commodity prices could be deflationary as they lead to higher food and the energy prices.This will lead to substantially diminished disposable income,drastically reducing the final demand ergo ,contributing to a drastic decline of non basic goods.
What the FED should really do is to lean on the key commodity exchanges including COMEX ,NYMEX and CBOT to raise the margins to 100% of the contract's value. That would lead to a major price decline and deflationary trend in the crude and grains.This price adjustment would allow the FED to ease more aggressively in order to secure a major economic rebound.Not too long ago the FED had lowered the FF to !% for no reason.Given the record economic leverage deployed in the global economies it would be a mistake to precipitate another debacle(raising rates will) .The sequential set of events that could follow ,would dwarf the economic consequences of 1929. Alternatively ,deflating commodity prices via 100% margins would allow the FED to further accommodate a noninflationary (potential ) record expansion in the period ahead. I would like to note that the "Rent"is the component of CPI.Since 70 % of the Americans are homeowners ,why not substitute home prices for the rent component.The decline in the CPI would be significant.
Given the economic vulnerability of Europe and Emerging markets ,a massive capital flows to the U.S lie ahead contributing to unprecedented stock market rally (perhaps for the wrong reasons).Worried about the high crude prices? Let's subsidize extraction of the crude from the sands(Canada)

2008 Jun 23 09:58 AM

[User 143167:]

The oil bubble was helped by the money given out by the Fed. So the Fed is still the culprit. Let's kill the oil bubble, but these money will go to make other bubbles. People who love stock and housing bubbles so much but hate oil bubbles out of the same reason is no brainer.

2008 Jun 23 10:38 AM

[Chandler Lutz:]

Interesting article, but if the FED increases interest rates how will this affect the value of the dollar? If the value of the dollar increases and demand continues to fall, oil prices may drop leading to a rally. It is very difficult to predict the short term and long term affects of such an increase in these circumstances.

Also, preservation of capital should always be a top priority regardless of the state of the market or the economy not just in difficult times.

2008 Jun 23 11:09 AM

[moonbat1775:]

A lot of people know the banking system engages in systematic theft via inflation. They just hope the system will hold together for their lifetimes. (Except of course, the bankers and other looters.)

I wonder if the French thought similarly in 1789?

2008 Jun 23 11:26 AM

[John Pseudonym:]

If the price of oil drops, that will boost the economy. If the economy picks up, that will increase the demand for oil and inflation will reignite.

This is a death spiral and only an economic washout will fix the problem. Remember the early 1980's anyone?

2008 Jun 23 11:55 AM

[bearfund:]

I do hope Congress puts the kibosh on all this oil speculation. Ideally they'd just close the futures markets for it entirely, as India did for some commodities. I don't personally expect this will have much if any effect on the price (to be honest I expect prices would rise if the action were truly rash), but it's fine with me either way. If it doesn't, the anti-speculator crowd will be made to look like fools. If it does, everyone wanting to protect themselves from inflation will go back to where they've always gone when things get out of hand, the one market that is almost impossible for any government anywhere to crush. Got gold?

2008 Jun 24 12:28 AM

[bobandted:]

The Fed did make a serious error of judgement when embarking upon this aggressive rate cutting cycle. It would not have been so bad had the Fed's timing coincided with rate cuts by other Central Banks but the unilateral move taken by the Fed has had disastrous consequences for most global economies. The plunge in consumer confidence, rise in inflation expectations, erosion of equity wealth and bubble in commodity prices has all coincided with the Fed's kneejerk policy, to cut rates at a time when inflation continued to be a nagging problem. Investment banks have thanked the Fed for the bail out by pushing the subsequently cheaper money into commodity classes, thereby penalising Main Street by pushing up energy and food prices to near-farcical levels.

With Central Banks elsewhere now being forced to hike interest rates to offset against a commodity inflation surge sparked by the Federal Reserve. If the Fed decides to sit on its hands and do nothing, commodity prices will go higher, inflation expectations will rise and the US consumer will find itself in an even deeper pit. While raising rates now will undermine the Fed's credibility, it may be argued the Fed has barely a shred of credibility left, and its policy decision should be focused exclusively on what is required to best serve Main Street in what is fast becoming a deepening crisis. There is no point in talking the talk if the Fed is not prepared to walk the walk. The ECB acts tough when it talks tough while the Fed is seen to dance around the fire. The Fed should not wait around but should raise rates by 0.25% tomorrow and signal more is on the way. Only tough talk, followed by tough action, will convince inflation-raising commodity bulls the game is up, at least for now.

Bob B

2008 Jun 24 12:18 PM