Federal Reserve Holds Interest Rates Defying Wall Street

By: Money_Morning

Martin Hutchinson writes: The U.S. central bank's Federal Open Market Committee (FOMC) yesterday (Tuesday) left the benchmark Federal Funds rate target at 2.0%, after many had expected the central bank policymaking committee to cut rates in the wake of the Lehman Brothers Holdings Inc. ( LEH ) collapse.

What's more, the statement that was issued after the policymaking meeting was somewhat “hawkish,” suggesting that the U.S. Federal Reserve is awakening to the dangers of persistent and gently rising inflation. Wall Street was initially spooked; it had hoped for the usual bounce that follows a Fed rate cut. However, investors subsequently decided the Fed's inaction meant things weren't so bad after all. Actually, the inaction was the first example in several years of the Fed doing its job – standing up to the easy-money politicians and Wall Street in the pursuit of lower inflation.

The Consumer Price Index (CPI) for August registered a decline in prices of 0.1%, which observers hailed as an indication that inflation worries are at an end. But don't you believe a word of it; the decline was entirely due to the recent fall in oil prices, which we here at Money Morning expect will one day reverse course and resume their upward march. The only question is when that will happen and what the catalyst will be to make it so.

In terms of the CPI, the “real” consumer price inflation was actually 5.4% over the past 12 months, which makes the 2.0% Federal Funds rate look pretty silly.

The same is true all over the world: Inflation rates are either well above the local bank base rates (2.3% vs. 0.5% in Japan, 12.1% vs. 9.0% in India), or are only just below them (3.8% vs. 4.25% in the Eurozone, 4.8% vs. 5.0% in Britain). Only China has inflation of 4.8% to go against a bank rate of 7.2% – just reduced from 7.47% – but China had been holding prices down with direct controls for the Summer Olympic Games, so its current inflation number is pretty dodgy.

If interest rates are at or below the inflation rate in most of the world, then it follows that global monetary policy is expansionary and inflation can be expected to increase generally. You can't entirely blame the world's central banks; we have been in a “credit crunch” for more than a year now, and investment banks the size of Lehman and Merrill Lynch & Co. Inc. ( MER ) getting in trouble is a pretty good indication that all is not well. However, there's also no denying that low or negative real interest rates will tend to produce an acceleration of inflation.

The two objectives – saving the world banking system, and keeping inflation under control – are in conflict.

The market demonstrates the solution to the conflict.

On Monday the Federal Funds rate traded for much of the day at 6.0%, versus the Fed's target of 2.0%. To get the market Federal Funds rate down towards the target, the Fed needed to inject lots of liquidity, which it did – to the tune of about $70 billion. That liquidity increased the money supply, but only to make up for the decrease caused by bank failures and market fear, thus restoring the market's balance and lowering the Federal Funds rate to about 3.0% by the end of the day's trading. An interest rate cut Tuesday would simply have moved the “target” Federal Funds rate, rather than the actual rate, and would have led to more inflationary pressures without materially helping the banking system.

Indeed, one can wish that the Fed had confined itself to injecting liquidity throughout this prolonged credit crunch, keeping the Federal Funds rate level at its September 2007 level of 5.25%. In that case oil prices would probably never have soared to $147 a barrel, and U.S. inflation might have remained safely around 3.0%.

Going forward, it seems clear that next time the FOMC meets without having had about half of Wall Street disappear in the preceding week (the next scheduled meeting is Oct. 28-29), it will be tempted to announce a modest interest-rate rise, unless the U.S. economy is truly in the tank by then. Of course, the Fed would remain ready to lower rates again if a deep recession appeared, or to inject liquidity if more banks got in trouble.

That would suggest that the current sharp drop in yields on long Treasury bonds has been overdone (from 4.25% in June to 3.25% yesterday (Tuesday) morning, before rebounding to 3.49% at yesterday's close). Thus, a rebound in Treasury bond yield – taking them significantly above the level of inflation – is called for as money is tightened and the Federal Funds rate rises.

To take advantage of such a yield rebound, you should consider the Rydex Juno Inverse Government Long Bond Strategy ( RYJUX ), which invests in short futures contracts on long-term Treasuries, so could be expected to gain as Treasury yields rise.

News and Related Story Links:

• Bloomberg News : Fed Keeps Rate at 2%, Rebuffing Call for Reduction .
• Bloomberg News : U.S. Economy: Consumer Prices Fall as Energy Drops .
• Money Morning News Analysis : U.S. Investment Banking Sector's Rough Weekend Provides Investors With a Roadmap for Future Profit Plays .
• Money Morning News Analysis : How Lehman Brothers' Own Risk Management Strategy May Cause it to Fail .
• Money Morning Global Economic News Analysis : ECB and BOE Inject Billions, Bank of China Cuts Rates as Central Banks Cope with Lehman Fallout

By Martin Hutchinson
Contributing Editor

Money Morning/The Money Map Report

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