All Eyes on the Fed Signals on US Interest Rates and Inflation

By: William_Patalon_III

The U.S. Federal Reserve will be in the spotlight again this week - and not because of those speaking engagements that seem to help whipsaw investor emotions. Tomorrow (Tuesday) and Wednesday, central bank Chairman Ben S. Bernanke will meet with his fellow policymakers on the interest-rate setting Federal Open Market Committee (FOMC).

After one of the most aggressive rate-cutting campaigns in its history - a stretch that's seen the Fed pare its benchmark Federal Funds rate from 5.25% in mid-September all the way down to 2.0% today - most experts believe the central bank's next move will be to take interest rates higher to blunt inflation. But few of these Fed-watchers are willing to predict that the increase will be made now, or even in August, although the interest-rate-futures market is projecting such a possibility. ( Money Morning Contributing Editor Martin Hutchinson - an international-banking expert - predicted that reversal in policy well ahead of the masses, and says the move needs to be made sooner rather than later - if inflation is to be blunted).

After all, while "recession" may be off the table for the time being, the most recent economic releases point to continued sluggishness and higher rates could prove devastating to future growth.  Investors will await the Fed's accompanying statement, scrutinizing the text for clues about the central bank's view of inflation, and how it sees the escalation of food-and-energy prices feeding into overall prices [For a more-detailed analysis of the Federal Reserve's actions, check out this related story in today's issue of Money Morning ].

The consumer will play a major supporting role in this saga again this week with the release of several key reports that should provide some added insights into the mindset of the U.S. consumer.

Why should we care? Simple. The U.S. consumer is responsible for two-thirds of the country's economic activity, so investors should be quite interested in the latest confidence index reading and statistics on personal spending and income. 

In the eternal optimist corner, some investors will ask (or, more accurately, hope) that this will be the week that the housing releases (new and existing home sales) reveal that an upcoming sector rebound is on the horizon?

But as we've been saying since last fall, don't expect to see that turnaround anytime, soon.

Market Matters

Up until now, the central bank has been able to concentrate on so-called "core" inflation, which (as the tagline says) "ignores volatile food-and-energy prices." That strategy was acceptable in the past - in fact, it even worked well - because food-and-energy prices were somewhat erratic from month to month. So the focus on "core" inflation enabled the central bank to concentrate on what was "really" happening with the economy.

But that's no longer an effective strategy. Indeed, by ignoring food-and-energy prices, the central bank is actually ignoring what's "really happening" out in the marketplace.

Who says it's all about the "core" price data?  While much of the recent inflation focus has been on soaring oil and gasoline, the devastating Iowa floods have brought rising food prices right to the forefront of the current market debate .

Though feed prices have been climbing for the past few years, corn has surged more than 10% during the last two weeks, leaving farmers and meat producers worried about the appetites of those already "belt-tightening" consumers. Some blame the ethanol mandates for the shrinking grain supply and are turning to politicos for relief.

Meanwhile, crude futures encountered a volatile week last week as traders analyzed the contrasting news from aboard.  On one hand, the news that Saudi Arabia may be increasing oil production and that China is hiking gasoline and diesel fuel prices should dampen demand and move prices lower. On the other hand, Israel threatened Iran's nuclear facilities and rebels reportedly attacked a Chevron Corp. ( CVX ) plant in Nigeria late last week (both of which should contribute to higher oil prices).  For now, crude stands around the $135 per barrel level. 

Despite his low popularity rating, President George Bush has yet to relinquish the limelight as he blamed the Democratic Congress for the record gas prices.  Playing his own political game, President Bush proposed lifting the ban on drilling in certain environmentally friendly regions, knowing full well that such an idea will be met with great resistance.  He also acknowledged that such measures would have little impact on the current state of the energy sector as new drilling would take years to implement and even longer to generate any real results.

Lehman Brothers Holdings Inc. ( LEH ) announced a startling $2.8 billion loss in the second quarter, its first since going public, though the company avoided (for now) becoming the next Bear Stearns Cos. Inc. ( BSC ) by raising $6 billion in new capital.  Goldman Sachs Group Inc. ( GS ) and Morgan Stanley ( MS ) both reported declining earnings, though each bested The Street's already dire expectations.

Rumors have Merrill Lynch & Co. Inc. ( MER ) and Citigroup Inc. ( C ) taking more write-downs, negating prior speculation that the worst of the credit crisis had ended. That speculation resurfaces on a fairly regular basis, and whenever it does, we've emphatically told Money Morning readers to ignore it. Our view was supported this week over in Europe when analysts at Royal Bank of Scotland Group PLC ( RBS ) said looming write-offs would cause a global stock-market crash by September.

In non-financial corporate news last week, FedEx Corp. ( FDX ) reported a quarterly loss and projected a pretty negative outlook for 2009 due to soaring fuel costs.  After its snubbing by Yahoo! Inc. ( YHOO ) , Microsoft Corp. ( MSFT ) denied any interest in other Internet acquisitions at this time.  Continental Airlines Inc. ( CAL ) and UAL Corp. ( UAUA ) (United Airlines) are teaming up in a "non-merger" alliance to help create new revenue sources and cost efficiencies without the risks and red-tape of a full-fledged transaction. 

In the "misery-loves-company" category, the global markets struggled mightily last week as the Shanghai Composite Index fell to a 16-month low and has declined about 50% on a year-to-date basis.  Likewise, indexes in Tokyo, Bangkok, and Hong Kong have followed suit.

Here at home, the Dow Jones Industrial Index plunged below 12,000 for the first time in more than three months, as rising food and energy prices and ongoing negativity from financials continued to weigh on investors.  Bonds, which had come under pressure lately over future Fed policy, were the recipients of a flight-to-quality mentality as some investors sought the safe haven of the Treasury markets. For the time being, however, it's all about those skyrocketing food and energy prices.

But then again, don't economists always downplay "volatile food-and-energy prices" as they tell us to focus on so-called "core" inflation?

Economically Speaking

And The Survey Says… The Business Roundtable released results from its recent poll that showed corporate executives believe the economy will grow at a 1.3% pace in the year's second quarter (up from 0.9% in the 1st quarter, but still reflective of ongoing sluggishness).  While expectations have declined from the March survey when the trade group reported projected growth of 1.5%, the results seem to reveal that the executives' concerns about the dreaded "R" word have subsided - at least for now.

Meanwhile, more than 30% of CEOs surveyed believe that their companies will feel a labor pinch in the form of layoffs (or perhaps attrition) over the next six months. 

On the inflation front, the producer price index (PPI) surged by 1.4% in May, its largest increase since last November.  Further, the most recent surge in oil prices and the impact of the floods in the Midwest on food prices have yet to be reflected in this wholesale price gauge.  Fortunately, economists like to focus more on the core (ex-food and energy) data, which only climbed 0.2% in May.  (Apparently, the volatile food and energy prices are just as likely to fall as they are to rise, so they really shouldn't be counted…if only that were true, these days). The housing sector continued to struggle as May construction starts plunged to the lowest level in 17 years.  Additionally, the manufacturing sector suffered a setback, with industrial production for May depicting an output decline in the nation's factories, mills and mines.

Weekly Economic Calendar

News and Related Story Links:

• Money Morning Financial Analysis: Corn Prices Linger at Record Highs but Wheat and Rice Wear Thin .
• Money Morning Financial Analysis: Dallas Fed President Lends Credibility to Money Morning's Prediction That the Federal Reserve Will Soon be Boosting Interest Rates .
• Money Morning Financial Commentary: Saudi Arabia's Promise to Open the Oil Spigot is Nothing But Spin .
• Money Morning News: Oil Drops as China Ratchets Up Fuel Costs .
• CNNMoney.com: Nigeria Rebel Group MEND: Chevron Oil Facility Attacked .
• Money Morning Financial Analysis: Financial Fears Sweep the Globe After RBS Predicts Worldwide Stock-Market Crash.

By William Patalon III
Executive Editor

Money Morning/The Money Map Report

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