The Federal Reserve Bank (FED), led by Chairman Ben Bernanke, has orchestrated an economic recovery that has been highly controversial. Economists and investment strategists have debated the actions of the FED as being too loose or creating too much liquidity within the financial markets. If the FED has created too much stimulus through quantitative easing and an extremely low interest rate environment, many fear high inflation will soon follow in the near future. It is my belief that the recovery is extremely fragile, and the use of monetary policy, at least at this point, is necessary.
The main job of the FED is to control the level of inflation and to keep the unemployment rate low. Currently, inflation measured by the consumer price index (CPI) is between 1.0 and 1.5% on an annualized basis, and the current unemployment rate is at 8.9%. Historically, the US average inflation rate since 1965 has been around 3.2%, and the desirable unemployment has been between 5.0% and 6.0%. Since the financial crisis began back in the summer of 2008 the unemployment rate peaked at 10% last year, and inflation has been close to zero. There were even fears of a Japan-like deflationary cycle in 2009, which prompted the FED to act decisively by implementing its aggressive bond-buying program, and a near 0% overnight lending rate between financial institutions. Since that time, the FED has not changed course.
In Bernanke’s testimony to congress last week he continued to reiterate his stance regarding the stubbornly high unemployment rate, and the need to continue the $600 billion Treasury security bond buying program, and the FED’s commitment to keeping short-term interest rates at or near zero for an ‘extended period’ of time. The economy has in fact improved with very little inflation on the consumer, and the jobs situation in the US has began to make some notable improvements. However, commodity prices have soared, and producer prices have increased at a much higher rate than anticipated. The cost of food has increased by nearly 30% over the last year and gasoline prices are nearing the $4.00 level once again.
One of the biggest mistakes the FED made back in 2007-08, was the premature monetary tightening in the face of the unforeseen credit collapse that ensued in the second half of 2008. At that time, oil prices were nearing $140.00 a barrel, and the threat of inflation spooked the FED into making some decisions they would like to have back. Most strategists believe this indirectly exacerbated downturn. The economy is facing similar challenges in 2011, with the price of oil over $115.00 a barrel and commodity prices nearing all-time highs. Bernanke is going to be very reluctant to raise short-term rates and abandon QE2 prematurely based on past transgressions and the geopolitical risks threatening the world’s oil markets.
There is no doubt the US is experiencing an economic recovery, and the employment situation is improving. The FED is mainly concerned with the headwinds that could derail this fragile recovery. Manufacturing is only operating at about 75% capacity, and there is still plenty of slack in the economy to warrant high producer prices. Even if producers try to pass along higher input costs to the consumer, foreign and domestic competition would certainly pressure those producers to ‘go at it alone’ and risk loss of future business. Moreover, consumer demand will not allow prices to increase at a sizable amount due to the fierce overseas competition for complimentary products or substitutes. In the short term we should not worry that higher commodity prices will force producers to raise prices of final goods and services, but the high cost of oil will undoubtedly put a dent in overall global consumer demand. This in turn will allow the FED to continue their accommodative monetary policies at least until the geopolitical tensions in the Middle East subside. However, this does not mean the stock market is going to act favorably in the short term. Over the next several months, the financial markets will probably correct significantly to compensate for the risks of lower corporate profits. Consequently, higher input costs (commodity prices) and softening consumer demand resulting from higher oil and gasoline prices, will eventually lower overall corporate profits. These two factors alone should keep the FED from tightening and allow these other factors to put a lid on inflation in the short term. The only factor, in my opinion, the FED is going to have a hard time dealing with is its ability to encourage a meaningful and sustainable job recovery.
