Federal Reserve & Interest Rates

Inflation remains a non-factor as the Labor Department released it’s April numbers for the Consumer Price Index on Friday.  Thus far there has been little or no pressure on the Federal Reserve to change it’s current stance on interest rates.

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.2 percent in April before seasonal adjustment, the Bureau of Labor Statistics of the U.S. Department of Labor reported today.  This index has fallen 0.7 percent over the last 12 months, due primarily to a 25.2 percent drop in energy prices.  The year-over-year declines in March and April are the first since 1955.

The price of oil went up slightly in May so we can probably expect a slight rise next month’s numbers but global demand for energy remains constrained and that will likely be the case to the end of the year at least.  This is of course a far cry from last year’s numbers, when oil was still trading at well over $100 a barrel.

Over the past six months we’ve seen oil and other items fall considerably as the rally in commodities took a sharp nosedive last summer.  The numbers are starting to flatten out however as it seems the economy has finally reached an equilibrium with the shifting global demand from one of the worst recessions in decades.

Food and apparel fell slightly during April, although demand should receive a slight boost as millions of Americans start to receive stimulus checks in the mail.  Retailers have had a difficult time over the past year and the steadily worsening employment numbers aren’t helping matters any.

Consumer spending numbers are also expected to be weak for the rest of the year, once the stimulus boost ends.  It’s not clear whether the Fed is still concerned about deflation  or not but I’m sure their prepared to inject more money into the system if it’s warranted.

The market has very low inflation expectations for the next few years, 5 year Treasury yields have been hovering around 2% for quite some time now. 30 year fixed rate mortgages remain under 5% although they have risen slightly over the past month.

All this point to the fact that investors don’t see the economy heating up for quite some time, regardless of how much money the government has already spend trying to fix things.

Over the past few months we’ve seen the Federal Reserve increase it’s balance sheet activities once lowering interest rates no longer became an effective monetary policy tool, since they rates were already at zero.  Despite the trillions of dollars the Fed has poured into the money supply, they remain convinced inflation concerns remain negligible at this point in time and a big reason is because the Fed is basically acting as a substitute right now for institutional investors who are wary of even committing to short term money markets.

Most of that money has gone into seclusion in the form of the flight to quality into Treasury Securities.  Back in December, short term Treasury yields fell to zero, the first time that has ever happened.  Keep in mind that the government is also spending more money than ever and  is expected to run trillion dollar deficits for at least the next three years.

Despite what the Fed thinks, some investors are still wary of inflation with demand for 5 year Treasury Inflation Protected Securities(TIPS) causing yields to actually fall below 0% last month.  Some of this also has to do with the fact that non-TIPS securities of similar maturity are also trading at record highs, so even the most skeptical investor does not see long term inflation much higher than 2% over the next five years.

Now most people don’t think this situation will last too long, how can it?  What we are seeing is a lot of people hiding their money away waiting for the market to hit bottom but when it does many people think that money will come back to the market fast seeking higher returns.

Even after the institutional money starts flowing back, the Fed may not necessarily slow down the pace of their balance sheet activities.  There is a belief held by some that we may well see the Fed actually encourage a slightly higher rate of inflation than normal in a couple of years down the road.

Most predictions have the U.S. economy contracting between 4% and 5% this year and possibly more if the recession continues to drag on.  Therefore we may see the Fed continue to increase the money supply at it’s current levels in order to jump start the economy once the recession ends.

The government has enjoyed extraordinarily low borrowing rates the past few months as investors have flocked to safe and secure Treasury Securities.  With equity markets reeling, the focus for many has been on preserving value as opposed to seeking profits but that situation can’t be expected to last.

There are already signs that investors are starting to leave their safe haven now that the calendar has turned.  The government is also preparing to auction a large chunk of debt next week, which will flood the fixed income market.

Sure, Treasuries are as safe as it gets but how long can you expect investors to be satisfied with a nearly zero percent return.  What does this mean for the government?  Well, with the President-elect Obama stating that the federal government will most likely carry a $1 trillion deficit for years to come, it’s not good news.

The national debt is going to balloon in the next few years and we are going to see the fixed income market flooded.  With that much supply entering the market the yields can’t help but rise.

The bad news for financial markets is that the Treasury yield is the baseline or foundation for the entire credit market, no matter how low the Federal Reserve lowers interest rates.  There is only a finite amount of investment dollars out there and we are going to see a big chunk of that going into government debt, which will leave less dollars for other sectors of the economy.

The national debt was a looming problem even before government spending exploded this year and this will only speed up the eventual reckoning.  Everyone knew that our deficit spending was unsustainable and now this latest outflow of fiscal spending has some experts wondering how long will it be before the America’s credit rating comes into question.