Interest Rate Roundup

Friday, April 25, 2008

Chatter heading into the Fed meeting

There's a lot of interesting chatter about what the Fed might do next week. Most of it seems to center on whether the Fed will finally stop cutting rates, or just cut rates one last time by 25 basis points and then signal a pause.

Here's an excerpt from a WSJ story on the topic yesterday:

"The Federal Reserve is likely to cut its short-term interest rate by a quarter of a percentage point next week -- but then may be ready for a breather.

"The Fed, meeting Tuesday and Wednesday, is likely to make what would be its seventh cut in eight months. The reason: Some officials see a case for more insurance against a deeper recession.

"But others are concerned a cut could contribute to inflationary pressure with little benefit for growth. That means the option of standing pat will likely also be on the table. If it does cut rates, the Fed could signal in the statement accompanying the decision an inclination to pause and assess the impact of its cuts, which have lowered the federal-funds rate to 2.25% from 5.25% since last year.

"Officials say the case for lowering rates further rests primarily on the value of additional insurance against a worse-than-anticipated economic scenario."

And here is a column from long-time Fed watcher John Berry at Bloomberg:

"Federal Reserve officials are wondering how long consumer-price inflation can stay in the neighborhood of 4 percent without undermining their credibility as inflation fighters.

"Over the 12 months ended in March, the cost of energy in the consumer-price index shot up 17 percent and food items rose 4.5 percent. The remaining three-fourths of the index, the so-called core CPI, was up a modest 2.4 percent.

"Like everybody else, Fed policy makers have been surprised by the repeated surges in world oil prices and more recently by record costs for corn, wheat, rice, soybeans and dairy products. And they have taken comfort that all that's needed to bring the overall inflation rate down is for key commodity prices to stabilize.

"Except that hasn't happened.

"The prospect of elevated inflation and the risk to Fed credibility make it likely that if the Federal Open Market Committee chooses to reduce its 2.25 percent target for the overnight lending rate at its meeting April 29-30, the cut will be only a quarter-percentage point after a series of larger ones.

"Fed funds futures contracts indicate investors yesterday put about an 80 percent probability on such a 25-basis-point cut next week.

"The contracts also put a 20 percent probability on the FOMC's leaving the target unchanged, which would be the better policy choice at this point because of the threat to the Fed's credibility."

My take: The Fed should stand pat (a course of action also suggested by James Hamilton over at the Econbrowser blog). I could even make a case for a 25-point rise, though I know that will never happen.

The fact of the matter is, REAL (inflation adjusted) interest rates have been driven well into negative territory (for more on this topic, click here). Negative real rates are inflationary. The last time the Fed drove interest rates deeply into negative territory -- in the wake of the dot-com bust -- it helped create a housing bubble.

It also helped set the stage for the long-term run up in commodity prices that we're all suffering under. Yes, there are plenty of other economic and fundamental reasons why oil, gold, and grains prices have risen. But the Fed has essentially thrown gasoline on the fire by slashing rates willy-nilly and driving the dollar into the gutter. A tougher approach to interest rates, while it could hurt the economy in the short term, could help quite a bit in the longer term by getting inflation back under control.


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