With food and energy prices soaring around the world and the value of the U.S. dollar declining, financial markets are starting to ponder the limits of easy-credit policies from the
The specter of global inflation has caused a shift in expectations for the central bank's next decision on interest rates, which will be announced next Wednesday. The futures market was recently pricing in a 96% chance of a 25-basis point cut to the fed funds rate, and a number of economists predict the Fed will halt its series of rate cuts after its April meeting.
"After next week, they're going to be in a wait-and-see mode," says Ryan Sweet, economist with Moody's Economy.com. "More likely than not, they're going to leave the fed funds rate at 2% and see how the economy rebounds in the second half of the year."
One week ago, the market was priced for 40% odds of a 50-basis point cut, which would have brought the Fed's key short-term interest rate target down to 1.75%. A month ago, the market saw 100% odds of a 50-basis point cut and 64% odds of a 75-basis point cut.
The shift has come as the stock market has clawed back from its 52-week low and credit fears have eased, but economists say the decline in odds of a rate cut has more to do with rising signs of inflation and fears that further monetary easing from the Fed will allow prices to spin out of control.
"Inflationary pressures that have been gradually building are driving the shift, and the Fed is going to start being more cautious," says Sweet. "The housing recession and credit crisis is testing the limits of traditional monetary policy, so the central bankers are more likely to focus on the new lending facilities that have been created in an effort to relieve some of the pressure on interbank lending rates."
The Fed has slashed its rate target by 300 basis points since the outbreak of the credit crisis last summer. Still, widened credit spreads only began to narrow after the Fed aided
( BSC), which was on the brink of bankruptcy in mid-March, and extended credit to Wall Street investment banks through a series of new lending facilities under authorities the central bank had not exercised since the Great Depression.
The implicit government backing of investment banks and mortgage giants like
( FNM) and
( FRE) also was welcomed by financial markets.
Inflation Concerns Rise
Inflation concerns, however, are again on the rise. On Tuesday, the dollar hit an
of $1.5991 against the euro, and crude oil closed at
of $119.37 a barrel.
Two members of the rate-setting Federal Open Markets Committee have fretted over the rising inflationary pressures. Richard Fisher and Charles Plosser dissented from the Fed's decision to lower rates by 75 basis points in March, preferring less aggressive action at the meeting. The
from its March meeting revealed that both men dissented out of concerns that expectations for inflation in the U.S. economy will become "unhinged" as the dollar drops in value while commodity prices rise.
"Mr. Fisher stressed the international influences on U.S. inflation rates," said the minutes. "Mr. Plosser noted that the committee could not afford to wait until there was clear evidence that inflation expectations were no longer anchored, as by then it would be too late to prevent a further increase in inflation pressures."
Paul Volcker, the former Fed chairman who slayed inflation in the 1970s by cranking up interest rates -- despite howls of protest on Wall Street -- said in a recent speech at the Economics Club of New York that the U.S. dollar is in "crisis" and inflation is a concern.
The merits of inflation concerns are hotly debated on Wall Street. Global Insight economist Brian Bethune argues that inflationary threats are overstated due to soaring energy prices, which are driving up prices in other commodities markets, while major portions of the U.S. economy, like technology and autos, are actually showing signs of deflation.
For his part, Fed Chairman Ben Bernanke has acknowledged that inflation measures have been "elevated," but he's forecasting that those measures will moderate in the "coming quarters."
"Headline inflation has become uncomfortably high, and at this point, inflation expectations have moved forward at such a rate that it is clearly making the Fed very uncomfortable," says Joseph Brusuelas, chief U.S. economist with IDEAglobal. "Fisher and Plosser are making very persuasive cases that the Fed should not give away the store on inflation."
Despite the shift in expectations, other economists point to the housing market's decline as evidence that the economy will not be rebounding in the second half of this year. Even as inflation concerns grow, they argue, the Fed will eventually be forced to continue lowering rates.
Fed officials don't want to be remembered as the guys who went down failing to prevent the second Great Depression," says David Merkel, chief economist with Finacorp Securities and a contributor to
. "That's the elephant in the back of their minds, which makes me think that inflation will go a bit higher before they finally say they have to go after it. It's a rotten situation, and Ben Bernanke is a bight guy, but he has been dealt a rotten hand."
In addition to promoting price stability, the Fed also has a mandate to promote full employment in the economy, and Merkel says this is being complicated by a process that he calls "debt deflation." Big banks like
( MER) and
Bank of America
all have reported billions in fresh writedowns tied to bad mortgages and other credit.
"You have a huge amount of bad debts in the financial system that are not worth the face value of the paper that it was written on," says Merkel. "The Fed probably can't fix this problem, but it will try because it's so politically big. They're trying to prevent a downturn by throwing a lot of credit at the problem. The other alternative is to allow the debts to deflate and let the banking system come back with whatever healthy banks survive the shakeout, which probably amounts to another Great Depression scenario."
Given the Fed's options, Bank of America economist Mickey Levy doesn't think the central bank will be finished lowering rates after a quarter-point cut next week.
"The Fed is in a bind," says Levy. "But under historic circumstances like this, even though there are inflation pressures, they'll continue to lower rates."
Lehman Brothers economist Ethan Harris notes that investors got ahead of themselves in March, calling for a 100-basis-point rate cut from the Fed that became a disappointment when it was only 75.
"That was interpreted as a hawkish Fed not willing to supply what the market wanted," says Harris. "In fact, that was an extraordinarily aggressive move from the Fed. Now, everyone has run from one side of the ship to the other. They were expecting too much from the Fed, and now they're expecting much too little."
Harris points to the unsold inventory levels in the U.S. housing market as a sign that the foreclosure process has only just begun and the economic downturn is still in its infancy.
"The recession will kill the inflation problem," says Harris. "It's not unusual for inflation to pick up in the first half of a recession. It takes time for the problems in the economy to create unemployment and to cool of the commodity markets. Given how weak the economy is likely to be, it's only a matter of time before we start seeing friendlier inflation numbers."