What the Fed Will Do with Interest Rates?

“Whirlwind of activity” is a favorite cliché of journalists.  During most economic upheavals the press likes to use the phrase to describe what’s been going on at the Fed.  It’s descriptive, and it gives a certain sense of excitement that “bureaucrats held a lot of tense meetings” just doesn’t seem to communicate. 

But if a “whirlwind of activity” describes the normal busy time at the Fed, then “it’s tornado season” is just about the only phrase that would work for what’s been going on there recently in the wake of all the subprime-related madness. 

Indeed, Bernanke has been a busy man recently.  He initially tried to lay low and hold tight on rates to convince the markets of his inflation street-cred.  Soon, however, he faced a withering storm of criticism.  Pundits were literally screaming at him on national TV – for instance, type in “CNBC,” “Jim Cramer” and “flips out” into Youtube.

As the situation got as bad as everyone knew it was going to get, Bernanke was forced to cut rates in dramatic fashion.  It was just a few weeks ago that the Fed cut rates by the usually unheard of amount of three quarters of a point. 

Perhaps just as importantly, he has signaled in recent weeks that he is willing to see a return of the super-low interest rates that the country enjoyed at the beginning of the decade. 

As oil has moved from flirtation with the $100/barrel level to more of a steady relationship, however, markets have started to have real worries about inflation. 

These worries came to the fore this week as the country’s main inflation index, the CPI, came in significantly above expectations.  Forecasts had been for just barely 0.3%.  Instead, the numbers came in as a solid 0.4%.  That the CPI numbers surpassed expectations during the same week that oil seems to have readjusted upwards above $100/barrel does not help matters.

Furthermore, the housing starts numbers came in above expectations, at 0.8%. 

These three things – oil, CPI numbers and housing starts – have strengthened the dollar slightly as FOREX traders – if you take the press’ account for gospel – think it less likely the fed will lower rates.

So, is the Fed done for now?  It seems unlikely.  What has given the dollar a bit of a boost in the past few days has more to do with developments in England and the euro-zone that seem likely to force those central banks to begin regularly cutting rates. 

As these banks begin to lower their rates, it will give the Fed more room to maneuver, as a weaker pound and euro will slightly reduce the inflationary impact of the Federal Reserve continuing to lower its own rates. 

So, unless oil starts going crazy and pushing $105 or $110, look for the Fed to lower rates at a pace that is equivalent to about a quarter point during each of its meetings for the next several months.