A Few Drops of Prell

Michael J. Prell, the Fed's former director of research and chief domestic economic forecaster, made his debut Monday as a private analyst. Prell retired from the Fed in June after a 27-year career. He spoke to the clients of the International Strategy & Investment Group, which advises institutional investors and hedge funds. Thanks to ISI's Tom Gallagher and Nancy Lazar, I was fortunate enough to hear Prell's comments on "Risks for Monetary Policy." In a wide-ranging talk, Prell discussed several of the hot-button issues confronting investors now.

Interest Rates

When the Federal Open Market Committee meets next week, it will make no changes in the fed funds target rate , according to Prell. He foresees a lively discussion, perhaps even some arguments. In its public statement, the monetary authority will retain its current concern about an inflationary bias in the economy. Why? Either because the Fed members believe there remains an inflationary tilt to the economy or because they want you to think they are worried about such a risk, according to Prell.

Prell is, as you might expect, an inflation hawk. He said that the risk of accelerating inflation is greater than the financial markets are expecting. He looks for higher oil prices. He sees economic growth accelerating slightly from its current 2.5%-to-3% range. With labor markets already tight, he fears wage inflation that might squeeze profit margins.

If Prell's economic forecast is right, he expects the Fed to raise fund rates by early next year, not lower them. He expects the Fed will be forced to raise rates in response to signs of quickening prices to safeguard its reputation as an inflation fighter. He said that, short term, the FOMC will worry about the inflationary threat posed by the spike in oil prices. (Longer term, it will take a more sanguine view and realize that there is a vast ocean of oil to be profitably pumped out at price levels far below today's.)

The Euro/Dollar Intervention

Prell explained last week's intervention by the G7's central bankers. He said that the Fed does not want to precipitate a flight from the dollar. A dollar collapse would further exacerbate inflation at a time when the U.S. already faces labor and other economic constraints. So why did it back the intervention in the currency markets? Because, he explained, the dollar may have overshot the exchange levels anticipated by the Fed. Combine the overly strong dollar with surprisingly good unit labor-cost reductions, and the Fed may have felt it could risk giving the dollar a downward shove. (He also said that the euro intervention would likely be a subject of lively discussion at next week's FOMC meeting.)

He was agnostic about whether the intervention in support of the euro would be successful. He seemed to think that the Fed would be happy if it had simply helped stem the tide running against the euro. He doubted that the Fed had any desire to push the euro back up to its prior levels.

Prell made it clear that the Fed still believes in the wealth effect of a strong stock market. He said that a higher stock market could encourage the Fed to raise interest rates if his inflation forecast comes true.

Prell's Bottom Line

There is a significant inflation risk ahead and that will become more visible next year. The FOMC will therefore feel the need to act to raise rates. If the stock market were to fall between now and then, that might moderate the Fed's actions.

Stock investors who are leveraged and long will not take great comfort from his forecast.