The Federal Reserve's policymaking committee is about to give a new meaning to the term "bank holiday." After seven rounds of interest rate cuts starting last September, there are plenty of reasons for Chairman Ben Bernanke and the rest of the Federal Open Market Committee to take a long pause after today's cut of a quarter point, look at the effect of all the monetary stimulus it has flooded into the financial system, and ponder whether the central bank's next move should be an increase in rates that would mark the beginning of a tightening cycle.
1) Credit markets are on the mend. The recent backup in treasury yields seems to be signaling that investor anxiety has eased. The 10-year treasury yield is up half a percentage point from its March low as investors move away from this traditional safe harbor. This suggests, says the economics team at JPMorgan Chase, that "the possibility of a more extensive credit-market meltdown [has] dwindled sharply." The rising stock market, up about 9 percent since early March, can be seen as another sign of rising investor confidence. In any event, the Fed's various funding measures have not only helped add liquidity to the U.S. financial system but signaled that the Fed will do whatever it takes to prevent a complete financial implosion.
2) Inflation expectations are rising. While the monthly consumer inflation numbers are running as hot as they have in years, that's not what really worries the Fed. Inflation can surge, but as long as people expect it to subside in time, it's not such a big deal to policymakers. But if prices keep rising, then employers, consumers, and workers begin to anticipate higher inflation and start to factor it into what prices they charge or what salaries they expect. It's that inflation psychology that the Fed really fears. One way to measure inflation expectations is to look at the difference in yields between 10-year treasury notes and 10-year treasury inflation-protected securities. The gap between the two, a widely watched proxy for long-run inflation expectations, is up from about 1.9 percentage points in late 2006 to around 3.2 points today, as calculated by the Cleveland Fed.
3) The dollar is anemic. It seems that every day the dollar is marking a record low against the euro. Since the start of 2007, the greenback has lost about a fifth of its value against its chief currency competitor. As economist John Ryding of Bear Stearns puts it, "The foreign exchange value of the dollar is, in some sense, a reflection of the relative confidence in the monetary policies of the Fed and the [European Central Bank], and the dollar is falling victim to U.S. easing." Indeed, while the Fed has been debating how far to cut rates and how quickly, the ECB has held fast, as it's focused more on rising inflationary pressures in the Eurozone than on slowing economic growth.
4) Commodity prices are soaring. Both food and gasoline prices keep surging, thanks in large part to the rising price of oil. But while geopolitical tensions, trader speculation, and global production problems all have a role to play in oil's ascent—which, in turn, is pushing crop prices higher—so does the weakening dollar, since investors have looked to commodities not only as a hedge against inflation but as a hedge against the tumbling greenback. Indeed, one recent study shows that if the dollar had remained stable since the beginning of its decline in 2001, the price of oil would be nearly 50 percent lower than it is today. And higher energy and food prices have served to work against a good portion of the Fed's monetary stimulus, plus making a hash of the Fed's hopes that declining energy prices would relieve inflation pressures.
5) The economy is weak but stable. Today's gross domestic product report showed the economy grew 0.6 percent in the first quarter. Despite all the troubles out there, from housing to credit to oil, the economy has refused to roll over. While the unemployment rate has risen, monthly jobless numbers and weekly initial jobless claims remain well below the sort of level normally seen during a recession. And with all that monetary stimulus—plus tax rebate checks—still working its way through the economy, there is a good chance the economy will firm up without any further Fed action.
Here is how bond manager Bill Gross of PIMCO sums things up in his May investment letter to shareholders: "Lower Fed funds? They would, in PIMCO's opinion, likely do more damage than good from this point forward. Foreign and domestic investors are being fleeced with negative real interest rates, and the weak dollar, stratospheric commodity prices, and steadily rising import inflation are the result."
So if the Fed's next move, after a pause, is a hike, when will that happen? Bear Stearns's Ryding notes that the Fed has never raised rates after a recession—a situation he thinks the economy currently is in—until the unemployment rate has peaked, which he doesn't see happening until the middle of 2009. So, look for this Fed holiday to turn into an extended vacation.