What will be the Federal Reserve’s next move?

The Federal Reserve Board has got to be puzzled by the contradictory messages in the US macroeconomic data. The inflation data gets worse but the economic growth data suggests a slowdown ahead. So what will the FOMC do? First, keep the data in perspective.

By Matein Khalid

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Published: Sun 17 Apr 2005, 10:20 AM

Last updated: Thu 2 Apr 2015, 4:04 PM

Sure, retail sales, net exports and nonfarm payrolls all came low but one month’s data has no statistical significance. Retail sales in February and March were after all, on a roll. Sure, first quarter GDP might be a Tad lower than 3.5pc but it will definitely be way north of 3pc.

In any case, in a G-7 context, 3pc economic growth is excellent and would sent the Herr Chancellor and Koizumi – san turning cartwheels with joy in Berlin and Tokyo. Yet the dip in retail sales may well prove, as the Wall Street investment bank Goldman Sachs contend, the first sign that stratospheric oil prices now make the US consumer flinch. After all, higher interest rates and a 20pc rise in gasoline prices at the pump is the perfect recipe for a consumer slow down.

Still, the FOMC does not buy the slow economy, no inflation argument to pause in its measured credit tightening. After all, last weeks FOMC suggested that “distribution of possible inflation outcomes was now tilted a little to the upside.” Hello? The FOMC shares my call for higher inflation and 7pc LIBOR. So is the current soft patch just a statistical blip or the advent of the dreaded stagflation, when growth falls but inflation rises? Of course, stagflation is the nightmare scenario on Wall Street, thanks to the bearish financial markets of the Seventies. Both economic growth rates and inflation trend in their own secular cycles that may not necessarily bear statistical linkage.

After all, inflation peaked in the United States in 1991, amid George Bush Senior’s credit crunch recession and the invasion/liberation of Kuwait. Even though economic growth skyrocketed during the Clinton era, the golden age of Goldilocks, inflation did not rise and long US Treasury bond yields continued to trend lower. This is the power of secular disinflation and it should never be underestimated by an interest rate strategist. The Fed has a dual mandate to achieve price stability and growth. This business cycle is unique because of the tech bubble collapse, the Bush tax cuts, the disastrous impact of 9/11, the dollar devaluation against the Euro, the oil price squeeze since 2003, the Iraq war and, above all, Chairman Greenspan’s epic monetary ease to 40 year lows in US interest rates. The stimulus of tax cuts, a lower dollar, easy money and a war in the Middle East lifted the American economy from its post bubble recession.

Greenspan has raised the Fed Funds rate by 175 basis points in seven successive rate hikes since last summer but, adjusted for inflation, the benchmark US interest rate is still negative, inflation pressures will accelerate and the concept of a neutral rate is a joke. Most Wall Street economists contend the neutral rate is between 3.5pc to 4.5pc. So, ironically, we are in a world where the American central bank needs to continue to tighten credit even though the economy may slow down.

This is why the legions of UAE bankers and investors who believe LIBOR will remain extremely low because the Fed will finish its credit tightening once the economy slows down simply do not understand the dynamics of monetary policy in the Greenspan era. The Fed will be forced to hike interest rates even if the economy slows as long as inflation pressures accelerate. The March FOMC proved that inflation hawks led by the Chairman himself emphasized inflation risk in their balance of risk statement. Ever wonder why the dollar rose sharply against the Euro and the Yen despite the awful March retail sales, payrolls and $ 61 billion monthly trade deficit?

Strangely enough, long US T-bond interest rates are lower than when the Fed began tightening last June. The bond market does not share the Fed’s fear of inflation risk, even though the 10 year yield did rise half a point in the last four months. A hot jobs market could lead to wage increase but we are not at that point yet. Bond yields will only rise when the American economy generates three or four months of successive 250,000 payroll growth. Of course, indiscriminate buying by Asian banks to manipulate their one currencies in the foreign exchange market has kept long in term interest rates low and the dollar decline from turning into a free fall.

Short interest rates have a long way to go higher. The Standard and Poors chief economist believes the Fed Funds rate will be 4.5pc by Christmas. I totally agree. Yet the Fed will continue raising interest rates well into 2006.

That is the reason the dollar has bottomed against the Euro, Yen, Sterling, Aussie, the Swiss franc and gold. LIBOR will be 7pc next year, if not higher. Protect yourself before it is too late.



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