Fed Keeps Rates Low, Despite Rising Inflation

While the Federal Reserve's Open Market Committee (FMOC) met last Tuesday and Wednesday, both major U.S. inflation indexes were released. First, on Tuesday, the Labor Department announced that the November Producer Price Index (PPI) rose 1.8% (nearly a 24% annualized rate), due to an 8.7% increase in vegetables and 6.9% increase in energy prices, including a shocking 14.2% increase in gasoline prices.

The price of raw materials, known as "crude goods," rose 5.7%, which illustrates the inflationary impact of a weak U.S. dollar. Meanwhile, the core PPI, excluding food and energy, rose just 0.5% (6% annual rate), but economists were expecting only a 0.2% rise in the core PPI and a 1% rise in the overall PPI, so the November report was clearly a big surprise to those who wish the Fed to leave interest rates alone.

Then, on Wednesday, the Labor Department reported that Consumer Price Inflation (CPI) rose 0.4% in November, due largely to a 4.1% increase in energy prices. Excluding food and energy, the core CPI was flat. However, the "Owner's Equivalent Rent," which accounts for nearly 40% of the core CPI, will keep future CPI gains relatively muted, due to weak hotel rates, plus the ongoing housing and rental glut.

In the past 12 months, the CPI is now up 1.8% (and the core CPI is up 1.7%). As the CPI 12-month rate nears 2%, the Fed is going to come under increasing pressure to raise key interest rates in early 2010. But despite all this news of strongly-rising prices, the FOMC left rates alone on Wednesday, adding only that it intends to wind down its quantitative easing operations by February 1, 2010. The Fed also affirmed that it plans to terminate most of its domestic liquidity programs on that date, and others a few months later.

The Fed also said it was sticking to its existing plan to taper off and complete its scheduled $1.25 trillion purchase of mortgage-backed securities issued by Fannie Mae and Freddie Mac by March 31. Despite the Fed's intention to exit quantitative easing, the FOMC also made clear that it expects to keep interest rates at "exceptionally low levels" for an "extended period" and did not make any reference to rising inflation!

Some dovish members of the FOMC believe inflation is likely to remain so low that rate increases might not be needed until 2011. Others will want to move more quickly because interest rates are starting from such a low point. Financial markets anticipate the Fed will boost rates to 0.5% after mid-2010, based on federal funds futures. The Fed also acknowledged that the U.S. economy is picking up. I suspect that the faster the U.S. economy grows, the earlier the FOMC will raise key interest rates in the months ahead. (Navellier & Associates, 12-21-2009)

Here comes the late 70's and early 80's.