Fed Policy - An Update

In the last sketch (July/7) we highlighted the Fed’s apparent lack of concern for a weak US currency and the consequences, using the price of oil as an example.

Since then there has been a change in Fed rhetoric designed to indicate a growing willingness to support the $. First, Bernanke assured lawmakers that inflation is a concern for the central bank. Then Gary Stern, the long-time president of the Minneapolis Fed and a voting member of the FOMC said that, "We’re pretty well positioned for the downside risks we might encounter from here. I worry a bit more about the prospects for inflation. Headline inflation is clearly too high."

These two statements were enough to birth a change in view among Fed watchers and currency, bond and commodity traders. We had advised in the last post that either a rate lift or jawboning to that effect was necessary to firm the $. That was the result, the $ improving against most other currencies, especially the Euro. That is also one key reason that crude prices have dropped considerably, past few days.

Robert Craven

Bernanke - Out Of His League

Say the words "Federal Reserve" and you’ve lost your audience. As one friend noted, "These are the guys who have meetings every couple of months, do something or other with the money supply or interest rates or whatever. Fine. Now, as I was saying, the White Sox slugger Manny Ramirez..."

With this new site we intend to provide a layman’s guide to the Fed. And from that, something on the economy. A similar comment may appear under our Presidential Election blog given the preeminence of this topic in the electoral debate.

A dear friend responded to our recent post on oil; she wondered how if Fed-directed lower interest rates drive oil prices, may not this be self-defeating? That is, won’t higher oil prices restrain an expansion and isn’t, just the opposite of what the Fed is after? This provides a good start.

The Fed controls only the Fed Funds rate - the rate on short-term loans between prime banks. The idea is that by making liquidity available lenders will lend, borrowers will borrow and off to the horse race. The fed funds market can be considered the heart of the system under today’s operating procedure; or better yet, the horse trough; the Fed can fill ‘er up but no way to force ‘ol Jimmy (my Dad’s last horse) or Speedy-the-mule to drink.

The Fed has slashed fed funds from 5.25% to 2.00% in an attempt to spur the economy. Traditionally that works but this time not much happened. Why? Because 1) housing, responsible for perhaps 40% of all eco activity, has not responded as it traditionally does due to the bloated inventory of homes, and 2) the credit mkt is completely dysfunctional. Yet lower interest rates DO mean world investors are less likely to hold the $, especially as they have seen higher and higher signs of US inflation and a less-than-vigilant Fed, making the $ even less valuable in the future, THEIR VIEW. So they have been selling $'s, fleeing that market for other currencies with higher yields, and, for commodities (cheap to inventory with low short-term rates). Hence the weaker dollar. Hence the food/commodity price spike. Sure enough, the Producer Price Index is soaring.

But back to oil: Most oil contracts are in $'s. The weaker the $, the more expensive for US buyers as it takes more and more dollars to a given contract. The $ price of oil is up roughly 70% from late Q4, 07. I don't have the resources here but maybe 40% of that price spike at the pump is currency related - weakness vs the Euro, other currencies; much of the rest, as we indicated in the last sketch under the Robert Craven Report can be tagged to the perceived conflict and the accompanying dislocations in the Middle East given Iranian intransigency and the US/ Israel response.

So yes, our friend is on to something, but just half of something. Lower short-term rates don’t mean higher oil prices by definition. This is only true now because of $ weakness, the world’s perception that the Fed is behind the curve. The Fed’s duty as set out in the charter is to preserve the integrity of the US dollar. The Fed’s duty is NOT to avoid a recession at all costs. Although he doesn’t know it yet, Bernanke is now taking a moderate slow down and is close to creating a bruiser. So until Bernanke’s Fed begins to lift short-term rates, or at least jawbone to that effect we will experience a still weaker $ and higher commodity prices. The FOMC has to commit to long-term price stability or they will turn a slowdown into the worst of both worlds: a prolonged recession and excessive inflation.

Robert Craven