Fed Update: Issues With Data Dependence

Posted by urbandigs

Wed Jun 14th, 2006 09:40 AM

A: Wow, wow, wow. This morning started off with an unwelcome Core CPI rise of 0.3%, exceeding estimates of 0.2%. Fed Funds futures briefly trade beyond 100% in predicting a June rate hike.

According to CNN Money article:

The core CPI now is up 2.4 percent over the last 12 months. That's well above the target of a 1 to 2 percent 12-month rise in the core CPI which is traditionally seen as within the Fed's comfort level.


Fed Chief Bernanke has said repeatedly over the past few months that future monetary policy will be more 'data-dependent', sending shivers down the spines of investors and traders because if there is one thing the markets don't like, its uncertainty!

Now, the Core CPI data that came out this morning resulted in the fed funds futures contracts briefly going beyond the 100% mark in pricing in another rate hike at June's meeting! Thats bad for all those laymen out there with credit debt or adjustable rate mortgage products. The reason why 'data-dependent' judgement has issues is because technically speaking this Core CPI reading released this morning (which is showing a rise in inflation pressure) is really the result of monetary policy/economic activity from 9-12 months ago!

I talk about this alot here on UrbanDigs. US Economic data is lagging, meaning it is reported from data that happened months ago, yet the fed is monitoring it today and making monetary policy calls from it that won't have an affect for at least another 9-12 months! Get it? This is why the fed is stuck between a rock and a hard place.

Super high energy prices and precious metal prices from the periods of OCT 2005 - PRESENT are yet to show their ugly face in economic readings. Meanwhile the fed has no choice but to act on data it gets. The next 2 meetings are sure to be tough on equities investors and adjustable debt holders as more rate hikes are on the horizon. Even if the fed does pause, it is very possible that future data still will show the effects of past higher energy prices/commodities prices and will result in more rate hikes anyway.

WHAT THE FED SHOULD DO: Raise 1/2 point! Get it over with, issue a clearer statement saying the fed will now PAUSE and watch the effects of monetary policy. That will make everyone happy and prove that Bernanke is tough on inflation.

WHAT THE FED PROBABLY WILL DO: Raise 1/4 point and issue another 'data-dependent' speech in which 'further policy tightening might be needed' to combat inflation pressures.

EFFECT ON STOCKS: Interest rate hikes in general are bad for equities as the fed acts to hinder economic growth. Stocks are forward/leading indicators and as such will price in a slowdown in advance of it actually happening. Just look at the last 2 weeks and ask any stockholder how it is to own equities in inflation fearing times. There's an old saying in the stock market world, "Don't Fight The Fed"!

EFFECT ON US DOLLAR: As interest rates rise, the US dollar & fixed assets become much more attractive;. Short term CD rates right now are about 5.41% for a 1YR CD at Countrywide Bank. Not too shabby. Expect CD rates to continue to rise even AFTER the fed pauses. So, if you are going to invest in a CD, take out a short term one, 6 months say, and then lock in a higher rate when that expires!