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Wednesday June 25, 2008 - 01:50:09 GMT
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Forex Blog - Just Do It

Just Do It

Like in the Nike commercial, it is time for the Fed and FOMC to just do it…hike.  Lord knows the Fed lost no time in cutting rates last fall and through April.  Now that inflation and inflation expectations are rising and nominal and real short-term rates are low while long-term rates are already up, just do it.   Real Fed funds rate is negative and nominal Fed funds rate is low – policy is accommodative and will remain accommodative even with a quarter point hike.

This is a change for me…I have been in the economy is too weak camp to warrant a rate hike.  But I have changed my view.  No not on the economy.  Just on the realization that a quarter point rate hike tomorrow means little to the overall prospects for growth (on the downside).  Market rates have adjusted for some 125bps of tightening in the next year.  And hiking Wednesday would very likely do two things immediately to check inflation and inflation expectations…help the dollar firm and put a top in for oil. 

Dow Chemical today announced a 25% increase in prices across the board based on higher input costs (oil and its derivatives) and this followed a 20% hike in prices in May.  And if there is any question about where commodity prices are headed check out how much China’s steelmakers just signed onto for Australian iron ore – up to a 96.5% increase in price for the next year.  While China’s oil import bill is much larger and oil prices have surged, there is no sign that China is going to buy less oil. 

Even the Fed’s own growth forecasts suggest there is scope to hike without risking derailing the economy.  Waiting for weak growth to check inflation pressures is like waiting for Godot.  Fed has already said that the risk of a severe US economic slowdown has receded.   If growth is seen accelerating (even if still below trend) the notion that the Fed simply needs to wait for sub-trend growth to check inflation is indefensible.  The Fed too has more or less put a safety net around the banking system and a modest, albeit surprise, rate increase is not going to panic credit markets.  Sure home prices are still falling but mortgage rates have risen even with the Fed keep short-term rates on hold at low levels.  My sense is that mortgage rates might come down some if the Fed hiked Wednesday.

We know the ECB will hike July 03.  The Fed can’t sacrifice the dollar more ahead by threatening rate hikes and not deliver. A hike tomorrow would neutralize the impact of an ECB hike in July.   Sure the Fed news spin machine has been active reining in expectations of Fed tightening ahead – FT, WSJ and Washington Post.  But the bulk of the crossing of the deck of the ship has happened and a quarter point hike would not seriously threaten a major shift in fixed income positioning apart from short end of curve and even here I think the adjustment would be orderly.       

I used to think the Fed would hold off on hiking as banks needed a positively sloped yield curve for recapitalizing…that was before the early June jawboning campaign by Bernanke and others to get markets to adjust for possible rate increases ahead. 

A hike Wednesday would also give Bernanke some need inflation credibility/credentials.  Having some semblance of symmetry in responding to downside risks to growth as to upside risks to inflation is essential in checking inflation expectations (Conference Board today reported consumer 1-year inflation expectations held at a record 7.7% annual rate in June). 

Not moving Wednesday will also increase pressure on the Fed to hike more later – rapid rate increases the Fed itself warns may be needed if inflation does not respond to weaker US and global demand…well the jury is almost in and weaker demand is not checking inflation in any meaningful way.  Again home prices are not going to stop falling if Fed funds stay at 2.00% much less if they rise to 2.25% tomorrow.    

Yes I still believe the US economy is at risk of a severe downturn and that risk is rising not falling.  But I have also come to the realization that a “surprise” hike Wednesday would do something to check inflation while risking little on growth. 

No central banker is thrilled at the choice set – stagflation has a way of making central banking difficult.  But the lesson of the 70’s (this time is different no doubt) is that sacrificing price stability for growth is to be avoided (yes this is not a wage-price spiral and why we don’t need a Volcker Saturday night special on inflation).   So I am okay with 2.25% Fed funds even if the US economy slips into a recession.  My guess is that markets are not as dumb as they look…they will get the dilemma and see why a preventative rate hike is needed and market rates will not go berserk again and may even see lower rates as the Fed earns some respect on the inflation mandate.   

Now that I have said what the Fed should do what will it do?  Probably nothing on rates and try and craft a statement that addresses inflation and inflation expectations…higher rates needed in due course based on assumptions about growth.  But never say never to a Bernanke surprise Wednesday.  The credit markets, housing market and stock market are not at risk of a meltdown with a quarter point hike now.  So like the commercial says…just do it.

David Gilmore


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