While soaring oil prices have the markets buzzing about inflation, the
is poised to talk tough and take no action this week.
The stance reflects Fed Chairman Ben Bernanke's longstanding hope that oil prices will stop hurtling skyward and that inflation pressures will fade, but some investors are growing impatient with that mantra.
"At the Fed, they do all sorts of mental gymnastics to try to make it appear that whatever is going up in price has nothing to do with too much money being printed or rates being too low," says Bill Fleckenstein, president of Fleckenstein Capital and author of
. "They have demonstrated with their actions that they have one concern and one concern only -- stimulating economic activity."
As far back as its policy statement in September 2006, Bernanke's Fed has voiced concern about inflation. Back then, with investors panicking about crude futures hitting the $70-a-barrel mark, the Fed said "inflation pressures seem likely to moderate over time, reflecting reduced impetus from energy prices."
Two years later, crude prices are above $134.65 a barrel, and the Fed has slashed its target for its key short-term interest rate by 325 basis points in less than a year to 2% in the hope of cushioning the financial system and the economy from the perils of the housing downturn and credit crunch. The Fed is expected to hold steady at its two-day meeting beginning Tuesday, but investors until recently were pricing in a likelihood of interest rate hikes later this year.
Several Fed watchers told
that it's highly unlikely that the Fed will actually raise interest rates in a stagnant economy with a presidential election looming in November and the national unemployment rate rising.
Additional rate cuts remain a possibility if economic conditions worsen or the credit crisis wreaks more havoc, but further easing in the wake of the central bank's dramatic actions over the last year would enrage inflation hawks and give rise to accusations of political favoritism at the central bank.
"The Fed doesn't want to be seen as favoring either political party, and interest rate cuts now would be seen as favoring the Republicans," says Richard Sylla, professor of economics with the Stern School of Business. "There's a tendency for them not to want to do things before an election."
This particular election season happens to be a period of grave consequence coupled with internal chaos for the Fed. The central bank is facing rising inflation on one hand and economic malaise on the other. And to top it all off, blame for both problems is being heaped onto the central bankers from all corners.
Jeffrey Frankel, a professor of economics with Harvard University's Kennedy School of Government, argues that loose monetary policy is weighing on the dollar, which in turn lends momentum to the run-up in prices for oil and other commodities.
"It stands to reason that if dollars are worth less, people selling commodities will demand more dollars for their product," says Frankel. "That doesn't mean monetary policy is the only factor driving up oil prices, but it is one factor."
Meanwhile, Fed critics say that the willingness of Alan Greenspan, Bernanke's predecessor, to crank down the fed funds rate to a record low of 1% in 2003 stoked the fires of the housing boom.
"When you have a speculative mania financed by reckless credit expansion as we did with this housing bubble, economic turmoil is a guarantee," says Fleckenstein. "Now, the Fed is trying to hold back the tide, but they really can't. The economy will get worse no matter what they do. They should try to be responsible and recognize that their easy money policies are what got us here."
If the Fed's critics are right, the U.S. may be headed toward a situation where its central bank could eventually be forced to raise rates dramatically in order to restore confidence in the U.S. dollar.
"At some point, the Fed may decide that if we're not going to become a banana republic, then it may have to put us through a recession in order to stabilize prices and build up confidence in the dollar so the world can stop worrying about American inflation," says Sylla, a co-author of
Two regional Fed presidents that are voting members on the Federal Open Market Committee, Richard Fisher and Charles Plosser, have dissented from recent Fed actions, favoring a more hawkish approach to addressing the rise in inflation expectations. Their votes will be gaining weight in the committee in the months ahead, since Fed Governor Frederic Mishkin recently announced plans
and return to academia at the end of August.
With Democrats in Congress bottling up the nomination process in hopes of reclaiming the White House in November, Mishkin's departure will leave the Fed with only four governors, while it normally has seven, and governors are viewed as being more loyal to the chairman than regional bank presidents.
"This is really bad timing for Bernanke and the Fed, because it's facing an almost impossible mix of challenges with politicians putting them under the microscope," says Lehman Brothers economist Ethan Harris. "It's going to be very hard for them to write the directive next week, because they don't really agree on things."
Moreover, dissension at the central bank goes beyond the voting of the committee. While Federal Reserve Bank of Richmond President Jeffrey Lacker has expressed support for holding rates steady now, the well-known inflation hawk also said recently that the Fed should be prepared to raise rates as the risks of weaker growth diminish. He also raised questions about lending programs the central bank has created to combat the credit crisis in a recent speech, saying that they distort private markets, encourage risky behavior and pose a threat to the central bank's independence.
"The innovative credit programs and other things we've done have gone beyond previously accepted boundaries," said Lacker. "It crosses a line into what is essentially fiscal policy to direct credit to particular sectors, creating expectations of similar treatment."
His comments about the Fed's willingness to extend credit to unregulated investment banks in return for mortgage-backed securities and other forms of private debt echoed those of Paul Volcker, the former Fed chairman credited with quashing the last outbreak of inflation suffered by the U.S. economy in the 1970s. He said the Fed's rescue of
from near-bankruptcy and its role in the firm's fire sale to
raised political concerns about "the proper use and allocation of government power" and "embedded economic interests and lobbying."
Fleckenstein says these Fed insiders are pointing out that "moral hazard" -- the prospect that market participants have incentive for excessive risk-taking due the expectation the central bank will bail them out, if necessary -- has been gradually increased by the Fed throughout Greenspan's tenure.
"They never stepped in the way to stop anything that was obviously outrageous from happening, but then when the cumulative effect of reckless speculation led to trouble, they would bail it out," says Fleckenstein. "Now, we've bailed out Bear Stearns, so Congress will say, 'Why don't you bail out
Bernanke, a Republican appointed by President Bush, is up for reappointment as Fed chairman in 2010, and any perceived politicization of the central bank on his watch could hurt his chances to keep his job, particularly if economic conditions worsen from here. His close working relationship throughout the credit crisis with Treasury Secretary Henry Paulson, himself a former CEO of
, has raised eyebrows, particularly after Bernanke recently began
in concert with the White House.
Peter Schiff, president of Euro Pacific Capital, said Bernanke's unwillingness to discuss the dollar before Congress suggests he is "being muzzled by the Treasury Department."
"He could talk about the minimum wage law, taxes, education, energy and kinds of stuff that has nothing to do with the Fed. Meanwhile, he's in charge of monetary policy, but he can't talk about our money?" Schiff asks. "Now he can because the White House wants to talk up the dollar, but they're not actually going to do anything about it."
Former Fed governor Lyle Gramley, a senior economic adviser with Stanford Financial Group, says that questions about the Fed's independence during an election year is nothing new.
"We run into this concern in the public mind every time we're in years divisible by four," says Gramley. "The decision facing the Fed today is whether or not this Fed is really willing to test the latent strength of this rather fragile economy by raising interest rates before they really have to."
Gramley said falling home prices could lead to another round of writedowns on mortgage-related assets, and banks have yet to come to grips with the losses they're facing on home-equity loans, auto loans and credit cards.
"This notion that somehow we're going to get back into stagflation again like we had in the 1970s and 1980s must be coming from young people who didn't live through that era," Gramley says.