Central Bankers Finally Tightening the Interest Rate Screws on Inflation

By: Money_and_Markets

Mike Larson writes: Believe it or not, it's finally happening. It's dawning on Federal Reserve policymakers ... and on many other global central bankers from Canada to Asia to Europe ... and beyond. The "it" they're starting to accept?

It's time for tighter monetary policy.

Frankly, I'm thrilled. I've been arguing for some time now that they simply can't run monetary policy so loosely at a time when commodity prices are surging. They can't keep interest rates below the rate of inflation forever. And they can't just ignore rising prices and resort to that most dangerous of investor emotions — hope — that it'll all go away.

Instead ...

The High Priests of Finance Have to Take Action Right Now!

And that's what is finally starting to occur. Just consider the
following ...

• European Central Bank President Jean-Claude Trichet warned in no uncertain terms that the ECB is prepared to raise its main policy rate, currently 4%, in July. The ECB never followed the Fed's panicky policy path over the past several months. ECB officials have also been among the most hawkish of all those on the global stage. So you might be forgiven for dismissing Trichet's comments if he was out there by himself twisting in the wind. But he's not — not any more, anyway ...
  
  

  As inflation explodes, wreaking havoc on the U.S. economy, embattled Federal Reserve Chairman Ben Bernanke is coming under fire from both Wall Street and Capitol Hill.

• Brazil raised its benchmark interest rate by half a percentage point to 12.25% earlier this month. Russia just raised its benchmark rate by another 25 basis points to 6.75% — the third increase in 2008. And this week, the Reserve Bank of India boosted its repurchase rate to 8% from 7.75%. The Bank of Canada also halted its series of recent interest rate cuts, opting instead to keep rates unchanged. Most importantly ...
  
• One of the easiest central banks around — our own Fed — has now changed its tune. In a crucial policy speech in Boston earlier this week, Fed Chairman Ben Bernanke said that:

  "Inflation has remained high, largely reflecting sharp increases in the prices of globally traded commodities ... Moreover, the latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations. The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation."

It wasn't just Bernanke sounding the alarm, either. Fed Vice Chairman Donald Kohn also noted that it's "very important to ensure that policy actions anchor inflation expectations."

Look, I've been following the Fed for over a decade. And I've been closely watching what they've been saying and doing since this credit crunch began. These speeches are the first signs that the Fed is seriously considering a shift — from focusing on supporting economic growth to tackling inflation.

In sum, they're finally coming around to what I've been saying for years now: Ignoring the dollar decline, the surge in commodities, and the hazards of negative real interest rates is a sucker's game! Sooner or later they're going to be forced to confront those inflationary threats head on, even if it means the U.S. economy suffers in the near term.

The federal funds futures market is now pricing in the possibility of at least one interest rate hike before the end of 2008. That's a violent shift from several weeks ago, when additional rate CUTS were on the table. I wouldn't be surprised to see those expectations firm up even more if we continue to get ugly news on the inflation front.

Will it be enough to cut inflation off at the pass? I doubt it. China and other emerging markets are still driving up demand. Moreover, in the U.S., the real Fed funds rate (after adjusting for inflation) is now roughly two full percentage points below zero. Even assuming no worsening of inflation, it's going to take a lot more than talk — and more than a few minor hikes in the Fed funds rate — to make a significant difference on the inflation front.

So What Does This Policy Shift Mean to You?

First , for your fixed income money, do what we've been advocating in the Safe Money Report for a long, long time: Stick with some of the shortest-term Treasuries out there, like three-month bills. The maturities on these securities are so short, they aren't subject to the big price declines that can hammer long-term bonds. Plus, you can reinvest your funds at higher and higher yields as short-term rates rise. Another option is a Treasury-only money fund.

Second , consider hedging your interest rate exposure. There are both mutual funds and exchange traded funds that allow you to "short" the bond market. In other words, you can buy these funds and watch their value RISE as bond prices fall and interest rates increase. And boy, are rates ever increasing! Yields on the 2-year Treasury Note have rocketed from below 1.5% around the time of the Bear Stearns collapse to just under 3% today. It's extremely rare to see yields double like that in so short an amount of time. But it's exactly the kind of increase I've been afraid of — and have warned you to expect. Meanwhile, 10-year Treasury yields just poked above 4.1% for the first time since the end of 2007.

Third , if you have an adjustable rate mortgage and you're approaching your rate reset date, what are you waiting for? Refinance to a fixed rate loan and take that uncertainty about future payments off the table. You may also want to consider swapping out of other forms of variable rate debt (like home equity lines of credit) into fixed-rate instruments. Of course, higher interest rates and a tougher Fed aren't doing the stock market any favors. And I'll give you one guess which sectors have been hit the hardest. That's right — it's the home builders and financial stocks. I have warned over and over in these cyberpages that you should avoid them like the bubonic plague. Now all those Wall Street shills who were calling a "bottom" in these stocks months ago can't sell 'em fast enough. Unbelievable!

Bottom line: These are tricky times in the interest rate markets. I'll do my best to help you navigate all the twists and turns — and help you protect your valuable nest eggs from the dual threat of rising rates and sinking rate-sensitive stocks.

Until next time,

Mike

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