Fed rate cut likely last of year; oil-fueled inflation feared
The Federal Reserve, confronted with record-high oil prices nearing $100 a barrel and unexpectedly strong economic growth of 3.9 percent in the summer quarter, on Oct. 31 lowered interest rates but indicated it would be the last easing this year because of the rising risk of oilfed inflation.
The Fed’s quarter-point cut in its lending rates for banks — which banks are expected to quickly pass through to consumers — came as reports showed the economy remained robust and resilient, despite an intensification of the housing recession caused by a mortgage crisis in July and August.
The Commerce Department said consumers and businesses continued to spend freely and were largely undeterred by the housing turmoil, contributing to a nearly 4 percent growth rate.
Income growth remained strong, and inflation also was remarkably tame during the quarter, running at a 1.6 percent rate, thanks in part to a drop in oil and gasoline prices. But that trend has since reversed course. On Oct. 31, premium crude prices surged to a record of $94.53 in New York trading on signs that stockpiles of fuel are dwindling only weeks ahead of the winter heating season.
The sharp gains in oil and other commodity prices provoked consternation at the Fed — and apparently divided the Fed’s rate-setting committee — not only because of their potential to reignite inflation after hard-fought improvements this year, but because the Fed’s move to cut interest rates in the last two months was partly blamed for creating the price spiral.
The rate cuts prompted a sharp weakening of the dollar, causing a rise in oil, gold and other commodities that are priced in dollars. Worries about inflation apparently were strong enough at the Fed’s two-day meeting that Thomas Hoenig, pres- ident of the Fed’s Kansas City Reserve Bank, voted against the rate cut in a rare dissent at the consensus-seeking central bank. Analysts said the inflation concerns his vote reflected probably forced the Fed to signal it does not expect to cut rates again.
“We think we are done easing” is the clear message in the Fed’s statement, said Stephen Stanley, economist at RBS Greenwich Capital, noting that the Fed’s assessment that inflation risks are now equal to recession risks “had all the subtlety of a sledgehammer.”
The Fed acknowledged that the economy is likely to perform more poorly in coming quarters as it continues to be pulled down by the housing debacle and consumers and businesses slowly react to the credit crunch and drop in house prices. But it said its cumulative rate cuts, totaling three-quarters of a percentage point, “should help forestall some of the adverse effects on the broader economy.”
“We are surprised at the degree of hawkishness” barely a month after the Fed reversed course and initiated a dramatic rescue of the economy, Mr. Stanley said. One reason the Fed is trying to be unusually clear about its intentions, he said, is to “end the cat-and-mouse game where the market forces” it to cut rates by pricing in anticipated Fed actions, he said.
Still, the Fed has “plenty of flexibility if things turn sour on either the economic or the financial front,” he said. Stocks rallied on the rate cut, but bonds fell and the dollar continued its slide.
Roger M. Kubarych, economist at Unicredit Markets, said it is not clear what the Fed will do next, since worries remain about both inflation and recession. Given the stellar performance of the economy despite the deep housing slump, however, he said the Fed will not cut rates again unless it sees clear weakness in other sectors.
“It will take either a sizable increase in the unemployment rate or a big drop in consumer spending to force another easing move,” he said. Consumer confidence slumped this month, but job gains appeared to remain solid as ADP, the largest payroll processor, reported a large 106,000 increase in employment.
Richard Yamarone, an economist at Argus Research Corp., said the Fed focused on the 20 percent drop in housing investment reported by Commerce, and surmised that renewed housing woes will significantly crimp consumers, who have tapped into their home appreciation in recent years to finance spending on an array of things from cars to college educations.
But worries about the consumer are overdone, he said. “The consumer has managed to exhibit tremendous resiliency to so many influences” without capitulating, including recession, war and disaster, he said. “Housing prices have increased about 111 percent over the last decade, and now that they are off about 4 percent, everyone believes consumers will toss in the towel.”
Mr. Yamarone said the Fed is right to refocus its efforts on inflation. Not only is oil getting to threatening levels, food prices are “at elevated and irritating levels,” and announcements of price increases in everything from hamburgers to toothpaste have become commonplace.
“We do not expect further easing by the Fed, since the economy is in no apparent need of stimulus,” he said. “The Fed slashing rates in this environment is kind of like watching your neighbor start up a barbecue with a gallon of gasoline and a Zippo.”
Traders at the Chicago Board of Trade frantically signaled orders in the 10-year options pit Oct. 31 after the Federal Reserve sliced its benchmark interest rate by a quarter point, in what is likely to be the final reduction it will offer.