Fed Rate Hike Ready or Not?

On Friday, June 7th the US unemployment rate spiked from 5.1 to 5.5 percent - its biggest rise in 26 years. The currency market reacted predictably pushing EURUSD to within 2 cents of its all time high on the assumption that Fed would not dare tighten rates in such a precarious economic environment. The following Monday however, Fed Chairman Ben Bernanke dismissed all the hand wringing, noting that “The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.’’ More importantly Dr. Bernanke added that “The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations.’’

This was a tremendous change in tone from the Fed Chairman who for the past 18 months has spent most of his energy combating the negative economic effects of the housing bust and the credit crunch by methodically lowering rates from 5.25% to 2.00%. Clearly the game has changed and the Fed now felt that inflation was a bigger problem than growth for the US economy.
What has prompted such a radical turn around in monetary policy? Oil. The price of crude has skyrocketed to nearly $139/bbl creating a massive inflationary domino effect throughout the global economy. With oil a key component in everything from farming to transportation, to travel and tourism no sector in the US economy has been immune from the pain of higher prices. Headline inflation has increased to 4% from 2% the year prior. Worse, after years of stable and steady prices US inflation expectations have suddenly started to surge hitting a 13year in the latest Reuters U. of Michigan survey.
Indeed Fed Vice-Chairman Kohn echoed the concerns of most US monetary policymakers when he stated in a speech on June 11th that, ““Repeated increases in energy prices and their effect on overall inflation have contributed to a rise in the year-ahead inflation expectation of households,” Adding that "any tendency for these longer-term inflation expectations to drift higher or even fail to reverse over time would have troublesome implications for the outlook for inflation,"
While the Fed is clearly concerned about the near term negative impact of inflation on the purchasing power of US consumers, Dr. Bernanke and company are truly worried about the toxic possibility of wage-price spirals that plagued US economy in the late 1970’s early 1980’s when rates hit double digit highs and US suffered its worst recession since the 1930’s. So far wages in US have remained relatively muted as pressure from globalization has kept most US salary increases well contained. However, a sustained rise in prices is sure trigger much more aggressive wage demands from employees and could unleash a super cycle of inflation in the US economy that would be much more difficult to contain and would take much longer to defeat.

The Fed therefore has targeted to the price of oil as enemy number one for the US economy. By threatening to raise rates the Fed hopes to drop the price of oil in three ways.

  1. A possible rate hike will lead to strengthening of the dollar whose record weakness was one of the factors that drove crude prices higher.

  2. Higher US rates will make speculation in oil markets more expensive, forcing liquidation of some highly leveraged long positions

  3. Higher US rates will create further slowdown in US economy, lowering actual demand for crude

Indeed, the last point is the most problematic in this whole scenario as few market participants believe that the Fed would engage in a restrictive monetary policy in the middle of US Presidential election. A rate hike would likely increase the ”misery” index (a combination of unemployment and inflation) in the near term and skew the election against the incumbent political party. However, although the Fed tries to remain strictly apolitical, this time US policy makers may feel they have no choice. With US election fully five months away, Fed officials may feel that they do not have the luxury of time to wait until it is over to enact the necessary policy. The need to nip inflation expectations in the bud may outweigh any concerns about exacerbating the slowdown in the US economy.

Oil therefore remains the key variable to watch. If crude prices continue to hover near their all time highs, the pass through price hikes will infect the whole US economy, creating a dangerous inflationary mindset amongst the US consumers. In order to combat price instability which can inflict tremendous long term damage to the US economy, the Fed may raise rates whether the markets are ready or not.

The move should prove supportive of the dollar and in fact already is as the greenback has recovered nearly 400 against the euro points from its post NFP lows. If the Fed’s mentality has changed so will the attitude of the currency markets. The EURUSD could target 1.5000 or lower in sessions ahead as more traders come around to the new hawkish view of the Fed.

Only two possibilities could alter this scenario. If oil comes off the highs naturally and remains well below $130/bbl taking gasoline prices below $4/gallon, the Fed may not have to act as inflation expectations could ease by themselves. Finally if the Fed fails to back up its rhetoric with action, in effect playing a major game of bluff with the market, greenback’s recent gains could quickly evaporate as US short term rates will once again decline.