Right Time to Focus on Inflation

In the last two weeks we saw mixed May economic releases, from an expanding non-manufacturing sector and improving chain store sales, to continued declines in payrolls and a surge in the unemployment rate. Together, they added up to a soft but still growing U.S. economy. The Fed has been very effective through its aggressive monetary policies to sustain economic growth and minimize harm from collapse of the sub-prime mortgage market. The Fed’s powerful doses of rate cuts that started last September along with the government’s $170 billion stimulus package, including rebates for people and tax breaks for business, have stalled a potential recession expectation and should bring about better economic conditions in the second half of this year.

The Fed’s aggressive rate–cutting campaign also has contributed to lowering the value of the U.S. dollar. That, in turn, has helped to push up prices for imported goods flowing into the United States and has fueled a rise in consumer prices. Crude-oil futures surged more than $11 last Friday to more than $138.00 a barrel, continuing a furious two-day rally sparked by a sharp decline in the value of the U.S. dollar. The U.S. Dollar Index, which measures the greenback’s value against a basket of six foreign denominations, was down 0.8%, or 0.60 points, to 72.44. The dollar continued to drop sharply with the euro at $1.5758 in recent trades. The fall will continue unless the Fed stops lowering the interest rate and starts planning to increase the rate by end of this year. The European Central Bank continues to increase its interest rate to boost its currency and reduce the inflation-increasing momentum.

Commodity prices will continue to rise unless necessary monetary policies are revised to boost dollar value. For now the Fed’s policies seem well-positioned to promote moderate growth. The negative side effect however has been increasing momentum for possible inflation, which could eventually stall the economic growth. The Fed needs to find an equilibrium point and use more scientific tools to divert from recession without aggravating inflation.

Lower interest rates and the significant slide of the U.S. dollar against other currencies have led to an “unwelcome” rise in U.S. inflation and will be a factor in inflation expectations. High oil and other commodity prices is a double-edged sword that can both a) put a damper on already weak growth, and b) spread inflation across the globe. The announcement by Fed early last week that it is unlikely to lower official interest rates further due to significant concerns with rising momentum in inflation expectation is a right move but not enough to contain the growing inflation momentum.

If higher commodity prices persist, they could weigh down corporate earnings amid the energy crunch. Companies such as Ford Motor and Dow Chemical have surprised investors with news that earnings likely will suffer as a result of higher commodity prices (gasoline for Ford and oil-based feedstuffs for Dow). Airlines are taking a beating from high fuel costs. Retailers and restaurants are suffering as high gas prices keep consumers away.

Some of the burdens weighing on the dollar like the U.S. trade deficit are improving, and keeping the rate steady will serve as a cornerstone for dollar valuation turnaround. The Fed needs to shift this policy debate away from recession concerns and financial strains and be far more concerned with inflation and the falling dollar. This is the time for the Fed Chairman and Treasury Secretary to panic and prevent another disastrous economical meltdown.