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Surging Inflation Ensures US Interest Rates Headed Higher

Interest-Rates / US Interest Rates May 28, 2008 - 09:43 AM GMT

By: Martin_Hutchinson

Interest-Rates

Best Financial Markets Analysis ArticleThe inflationary reality that we as consumers have been living for months may finally be starting to dawn on the U.S. Federal Reserve.

The minutes of the last policymaking Federal Open Market Committee (FOMC) meeting, released on Wednesday, showed that the Fed's inflation forecast was raised from a range of 2.1%-2.4% to a range of 3.1%-3.4%. 


Add the zooming oil prices we have seen recently into the mix, and the conclusion is inevitable: The nation's central bank will soon have to reverse course and start raising interest rates - and probably in a hurry, too, if the Fed wants to keep oil prices on this side of the stratosphere.

That's no small shift: After all, for nearly eight months the central bank has been mounting one of the most aggressive rate-cutting campaigns on record, slashing the benchmark Federal Funds rate from 5.25% down to 2.0%.

The Key Catalysts

Several factors have made it imperative that rates head higher. Let's take inflation first. The consumer price index (CPI) figures for the last couple of months actually have been encouraging for the market. CPI has been coming in lower than analysts had expected. However, in both March and April, the downward seasonal adjustment was huge, far above the average adjustment for the past 10 years.

Thus, in March, a price increase of 0.9% (equivalent to 11.1% per annum) was revised down by the magic of seasonal adjustment to a mere 0.3%. Similarly, in April, an unadjusted 0.6% figure was seasonally adjusted down to just 0.2%.

It doesn't require a super suspicious person to find that odd, especially during a period in which everyone's worried about inflation . If the average March and April seasonal adjustment for 1998-2007 had been applied to the unadjusted figures, the annual rate of inflation for March and April would have been above 7%, instead of the 3.1% officially reported.

In any case, the producer price index (PPI) inflation is running at 6.5 % , which suggests the CPI figure could experience an uptick very soon.

Either way, if the Fed thinks inflation will be above 3%, and the monthly figures come in above that number - let alone as high as 6%-7%  - it won't be able to keep the Fed Funds rate at its current 2.0% for long. The FOMC knows quite well that a Fed Funds rate lower than the current inflation rate will only serve to fuel inflationary pressures, and force the inflation rate even higher. If the Fed thought inflation was at 2%, it could justify keeping the Federal Funds rate at 2%; but now that the FOMC has acknowledged that it thinks inflation will be above 3%, it's difficult to justify such a low Federal Funds target - something around 3%-3.5% seems more plausible, even if the United States is fighting a recession.

If monthly inflation numbers were all the Fed was worried about, we could expect the central bank to gradually ratchet the Fed Funds rate up to about 3% - or perhaps even a little bit higher. This deft initiative might get under way at the FOMC's June 24-25 meeting, or might start at its Aug. 5 meeting, but either way, short-term rates would reach 3% by the end of this year, unless the banking system suffered another real disaster before then.

However, the oil markets have given the Fed something else to worry about.

Oil prices at $133 per barrel last Wednesday were up 60% from the $83 per barrel level on Sept. 18, 2007, the day the Fed began easing cycle for interest rates [ oil prices punched through the $135-per-barrel level on Thursday before sliding back]. Other commodity prices have also gone through the roof during that same period. While U.S. monetary policy isn't the only thing affecting global oil prices, which are dollar-denominated, it's pretty clear that the Fed rate cuts and the central bank's creation of money through bailing out the banking system have made an awful lot of money available for oil speculators.

And while hedge funds and sovereign wealth funds are reaping these massive windfalls, don't forget the flipside of this equation …

This pricing petro-gusher is costing the United States real money.

The Suicide Squeeze Play

Since the United States currently imports about 9.4 million barrels per day, the $50 price increase since September has cost the United States $470 million a day. That's $170 billion per annum, more than 1% of gross domestic product (GDP), or 22% of the current U.S. balance of payments deficit.

T. Boone Pickens , the octogenarian Texas oil legend, has emerged with a prediction that the price of oil could reach $150 a barrel by the end of the year. He points out that the world oil supply is currently at a maximum of 85 million barrels per day, while demand is 87 million.

There's just one problem. There's no way this supply shortfall of just 2 million barrels per day, or 2.3%, should cause oil prices to soar 60% in eight months - let alone another 15% before year-end as Pickens predicts. Rising prices should reduce demand and (to a lesser extent) increase supply. Economists differ by how much, but no economist I know of thinks the price elasticity of oil is below 10%: And at 10% elasticity, a 2.4% supply shortfall should push the price up 24%, not 60%.

So where does the other 36% come from - not to mention the additional price increases that Pickens is predicting?

It must be "artificial" - that is, created by speculators.

With U.S. interest rates below the inflation rate, betting that oil prices will go up is like shooting fish in a barrel - you can't miss, provided only that you and your friends are together rich enough to control the market. And with all the extra money that the Fed has created just sloshing around, speculators are nothing, if not rich. 

How do you stop speculators? You whack them with a two-by-four, that's how. You get their attention with a shock move. You bring them pain by increasing their financing cost, you insert in their mind the idea that you might really mean it, and underscore that you might go on attacking them until their speculative run-up in oil prices is ended.

The Case for Higher Rates

The two-by-four that's needed for this financial markets game of Whac-a-Mole is a sharp (steep) increase in interest rates.

A series of small interest rate increases won't be enough. The Fed increased interest rates 17 times, by 25 basis points each time, between 2004 and 2006, and it had absolutely no effect on housing-market speculation - which, as we now know, was way out of hand. The market simply adapted to the increases and carried on. That's where the central bank brings the two-by-four 2×4 into action. You have to get the speculators' attention, whack them when they don't expect it, and do something they can't hedge against.

Here's one way to achieve that: Take back all of the interest rate cuts since September in one go, at a single Federal Open Market Committee (FOMC) meeting. Think about it: At 2:15 p.m., the customary announcement time, Federal Reserve Chairman Ben S. Bernanke discloses that the Federal Funds target has changed from 2% to 5.25%.

That ought to do it!

But what would happen to the U.S. housing market, whose struggles were the main reason why rates were slashed to begin with? After all, a little inflation is helpful; if wages follow prices, pretty soon everyone is earning more in money terms, house prices don't look so high, and the market can recover.

But with oil and commodities prices zooming up as they have, this comforting concept just doesn't work. Instead of getting richer, U.S. consumers are paying out more and more of their incomes to fill their tanks and feed their families. So in terms of spending power, they are getting poorer. Their ability to buy expensive housing is diminishing, not increasing.

Fannie Mae ( FNM ) said early last week that house prices across the United States could drop by an average of 25% . That's a huge amount. Such a decline would basically mean that all the mortgages taken out in the last five years would be underwater. If inflation doesn't bail the system out, then no amount of cheap financing is going to rescue housing. The mortgage market, Fannie Mae and its sister Freddie Mac ( FRE ) all are financial roadkill. Perhaps the U.S. government will rescue them, but there's no prize for guessing who will pay for that!

Based on reported inflation, the Fed is likely to start increasing interest rates by small amounts at one of the next two policymaking FOMC meetings. If the Fed or the politicians start panicking about oil prices - as they well may - the central bank can solve that problem by increasing rates much more sharply. And the best time probably would be between FOMC meetings, when nobody's expecting it.

Either way, interest rates are headed higher.

If that's your expectation, too, it's probably a good time to look at the Rydex Juno Fund ( RYJCX ), which takes a short position in Treasury bonds and, therefore, benefits when rates rise and Treasury bond prices fall.

[ Editor's Note : If the economic uncertainty - or the volatile markets - of recent months have you at a loss about the best moves to make next, check out Money Morning 's first book, " The Essential Investor's Playbook for the Next 12 Months ." At 118 pages, the just published guide provides an insider's look at the Top 16 global trends you're likely to face over the next year or more, and contains a special chapter with more than 50 profit plays - easily enough to dispel that uncertainty by enabling you to come out on top no matter what happens in the months to come.]

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By Martin Hutchinson
Contributing Editor

Money Morning/The Money Map Report

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