Inflation, Gas and the Economy losing ground…

August 13th, 2008

Faltering inflation expectations have led the Federal Reserve (the Fed) to hold rates steady for some time. Even though the Fed has cut its target interest rate to a level that should be stimulative, policy makers are still divided as to rather interest rates should be raised or remain the same. However, the majority feel that the rates should be left unchanged at least for the near term.

The recent turmoil in financial markets has made the Fed’s stance to err on the side of being too stimulative, rather than being overly restrictive with the target interest rate. It has become apparent that the Fed cannot raise interest rates without risking damage to the economy and financial markets. With the problems at Freddie Mac and Fannie Mae, banks came out with a fresh round of credit tightening which has caused the economy to become further depressed.

In interviews with mortgage brokers, the general consensus is that banks have over tightened requirements to obtain a mortgage. This is primarily because of banks concerns about being able to sell securitized mortgages to the secondary markets (i.e. Freddie and Fannie). With the continual tightening of lending, inflation has become an even more sensitive issue that the Fed must handle with care.

If the Fed raises the target interest rate there is the upside risk of less potential home buyers qualifying for a new loan. In addition, pushing up rates could lead to a fresh round of foreclosures because a raise in the target rate would push up the indexes that an adjustable rate mortgage uses as a bench mark to set interest rates.

With oil prices now down 15% this should curve “inflation expectations.” Fed chairman Bernanke qualified inflation worries, by saying he would need to see expectations embedded in U.S. wage – and price – setting behavior before lifting the target interest rate. With the current job market being weak and coupled with slower wage growth, the likelihood for an increase in the target interest rate in the near future is not probable. This sounds like we could actually be headed for a potential rate cut in the Feds funds for target interest rate.

Cliff Pape
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