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Lower US Interest Rates from the Fed are Not Likely

Interest-Rates / US Interest Rates Aug 20, 2007 - 04:28 PM GMT

By: Hans_Wagner

Interest-Rates Best Financial Markets Analysis ArticleEveryone seeking to beat the market from James Cramer to Wall Street big wigs are crying out for the U.S. Federal Reserve to lower the Fed Funds rate, the rate banks can borrow from each other. They believe that it will save the markets and help the firms recover from the mis-pricing of so many mortgage loans. However the Fed is not likely to lower rates in the near terms since inflation still looms on the horizon. After all fighting inflation is one of the primary missions of the Fed.

It's a Liquidity Problem

First, it is important to keep in mind the Fed is trying to avoid a credit problem not stimulate the economy. This credit problem stems from all the loans made by various lenders that did not properly account for the risk the lender was assuming. The primary examples are the no down payment and no documentation mortgage loans made in the last few years. These loans have lost substantial value and are now on the books of many investment institutions. By injecting funds into the markets and lowering the discount rate, the Fed is trying to avoid a credit crunch. I also hope they are not going to let the lenders get off the hook for their poor business practices.

Inflation is Still with Us

Second, the Fed is still fighting inflation. As measured the Consumer Price Index (CPI), inflation is running at a 2.4 percent seasonally adjusted rate, though we only saw a 0.1 point increase in July 2007, down from 0.2 point increase in June. However inflation had been growing a faster clip earlier in the year. 

In one of John Mauldin's weekly emails he mentions that year over year inflation is not likely to fall in the coming months. Basically this is because in the last half of 2006 we experienced very low inflation as measured by the CPI. This is likely to cause year over year comparisons to show higher inflation rather than lower. For those interested in John's free week email John Mauldin's E-Letter you can go here :

The table below is an extract from the Bureau of Labor Statistics, consumer price Index database which can be seen at . These are the actual numbers from the table and are not seasonally adjusted. But since we are comparing year over year this will not be a problem. Note that in September of 2006 the rate actually falls for several months. Now unless we see the same happen this year any year to year comparisons will show higher inflation, not lower. Also note that inflation grew at a 4.5 percent seasonally adjusted rate during the first seven months of 2007. Hardly good news.

Consumer Price Index (CPI)
Jan Feb Mar April May June July Aug Sept Oct Nov Dec
2004 185.2 186.2 187.4 188 189.1 189.7 189.4 189.5 189.9 190.9 191 190.3
2005 190.7 191.8 193.3 194.6 194.4 194.5 195.4 196.4 198.8 199.2 197.6 196.8
2006 198.3 198.7 199.8 201.5 202.5 202.9 203.5 203.9 202.9 201.8 201.5 201.8
2007 202.4 203.5 205.4 206.7 207.9 208.4 208.3

So that raises the question, how likely are prices to rise during the second half of this year. First of all last year food and energy prices fell in the later half of the year. They are rising now. With the growing demand for ethanol, we are seeing the prices of food that is dependent on a grain crop rise, in some cases substantially. 

As John points out if inflation were to slow in the second half of the year to 2% we are likely to see an index at 210.5 by November. This would lead to a 4% inflation rate year over year. Not the type of news the Fed wants to hear, nor likely to lead to lower Fed Funds rates either.

But the Fed always looks at the Core Rate, removing the volatile food and energy components. The table below shows an extract from the Core CPI table. Core inflation is also up for the year at about 2.3 seasonally adjusted rate for the first seven months of 2007.

Core Consumer Price Index 
Jan Feb Mar April May June July Aug Sept Oct Nov Dec
2004 194 194.9 196.1 196.5 196.5 196.6 196.6 196.8 197.4 198.2 198.1 197.8
2005 198.4 199.5 200.7 200.9 200.8 200.6 200.8 201 201.3 202.3 202.3 202.1
2006 202.6 203.6 204.9 205.5 205.7 205.9 206.2 206.7 207.2 207.8 207.6 207.3
2007 208 209.1 209.9 210.3 210.3 210.5 210.8

Again even if inflation were to fall to 2% in the second half of the year we will still see a core rate in the 2.4-2.6% range, due to the more difficult year over year comparisons.

Keep in mind that the Fed is looking for an inflation rate in the 1-2% range. So we remain on the high side of that level. This means that we are unlikely to see them lower their Fed Funds rate in the near future as they stay focused on controlling inflation.

Recession on the Horizon

So what is the argument for the Fed to lower rates. Basically those who believe the Fed should lower interest rates are saying that the economy is weaker then most think. The housing slump is causing much of the rest of the economy to slow and we are likely to see a recession by the end of the year or in early 2008. 

If we go back to the yield curve, remember it was inverted for a number of months. An inverted yield has been one of the best indicators of a recession 6 to 12 months in the future. Maybe this will hold once again.

However, the rest of the world is growing their economies and those companies in the U.S. that have a substantial part of their business from other countries are doing well. They should help the U.S. weather any slow down, as long as their economies are doing well. We are now in a global economy and we need to adjust our thinking. By the way you might consider reading Economic Growth by David Weil. It is expensive, but as a well written book, it presents the important factors that are affecting all investors in the global economy.

The Bottom Line

Investors should not count on the Fed to lower the Fed Funds rate any time soon, as long as the U.S. does not enter into an unforeseen recession. The U.S. is still experiencing higher inflation and it looks like it will remain so for a while. Also, the U.S. economy is no longer the only factor in the world economy. The rest of the world is growing at a rapid rate and investors need to consider the impact the economies of the world will have on the U.S. I believe the Fed understands this issue. 

By Hans Wagner

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at

Hans Wagner Archive

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Sherman McCoy
21 Aug 07, 15:42
Fed WILL cut interest rates

I disagree because -

First of all, real GDP is negative, because inflation is much higher than indicated by the CPI (

The "liquidity" problem we have isn't much different than that little liquidity problem that led to the creation of the RTC. Nor is it much different than the bad lending practices of banks in the early 90's tha led to a recession. Unfortunately, the government doesn't have the loose change to finance another housing bailout, since they're financing a new drug benefit program and a war.

You are correct that the curve inversion signaled a slowdown. The market already knows that the only way to prevent a recession is to validate the recent unprecedented steepness in the front end of the yield curve - 3mo T-Bills are at 3.56% - and lower Fed Funds 175bp to match.

The bond market is telling you a massive Fed ease is only weeks away.

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