Fed hints at a firming to contain inflation and firm the dollar

The Treasury and currency markets apparently accepted this weeks Fed statements at face value. But there is reason to doubt that the Fed meant exactly what it seemed to be saying. Before assessing the Fed statements it is necessary to repeat their general import.

The Fed this past week hinted that a Federal funds rate increase later this year may be necessary to head off rising inflation pressures. Fed Chairman Bernanke indicated the Fed would "strongly resist" inflation expectations. The comments seemed to squash any lingering remote hopes that the Fed would ease further after its easing pause ended.

Recognizing that the rapid surge in the price of oil and other commodities stems partly from the dollar downtrend, there was also a stepup in efforts by Fed spokesman and Treasury Secretary Paulson to talk up the dollar. In response to these comments, this week the dollar rose versus the Euro and Treasury yields increased sharply, especially in the short end of maturity yield curve. The Treasury two-year yield rose more this past week than any week since 1982, when inflation was running rampant.

Europen Central Bank's Triichet implied that an early firming to deal with inflation might be necessary. It is unclear if the Fed comments were deliberately coordinted with those of the ECB or were a verbal effort at self-defense in the face of an impending anti-inflationary ECB tightening.

The Fed only appeared to add credibility to its increased emphasis and focus on inflation by indicating that its concern over economic and financial weakness is receding. But that view is not justified. The run of financial losses and need for beleagered financial firms to raise new capital is far from over, This week Lehman Brothers indicated that the firm lost $3 billion in the latest quarter, its first loss since it became a public company in 1994. Furthermore, Lehman announced the loss will require it to raise $6 billion in additional capital. And they are far from being the only financial institution that needs to raise additional capital in order just to to be able to recognize losses, let alone to increase lending. Indeed, regulators are encouraging banks to cut their dividends as a means of rebuilding capial. Financial institutions, especialy investment banks, have to continue the deleveraging process. In addition, the Fed statements on inflarion led to a sharp increase mortgage rates that will only prolong and worsen the housing market debacle. The volume of foreclosures continues to mount, imposing a further heavy downward pressure on home prices and mortgage market losses.

And most significant, the employment picture has sharply worsened. The unemployment rate,already 5.5%, is likely to reach 6.0% by the turn of the year. The Fed is highly unlikely to firm in the midst of rising unemploment. Thus, the conclusion that must be drawn is that the Fed was essentially practising open mouth policy. If there is to be firming, which seems unlikely, it will be limited to a single one quarter point move just to reinforce the Fed anti-inflation intent. And even that will most probably only come after the November elections.

The realty is that despite fiscal stimulus and Fed easing, the US economy is confronted by the prospect of a prolonged recession and credit crunch. In time, that recession will engulf the global economy. That recession will supress inflation pressures and inflation expectations. And that process will produce a complete preversal of the rise in Treasury yields, producing new yield lows and further Fed easing.

Philip Braverman, President
Braverman Economic and Financial Consulting
One Hewitt Square #249
East Northport New York 11731

Philipbraverman@Gmail.com