What Will the Fed Do Tomorrow?

Short answer: Nothing.  The economic risks are currently balanced between the risk of higher inflation and the risks of a deeper recession.  Of course, think of balance as being a see-saw on the playground.  A see-saw can be balanced with a first grader on each side, or it can be balanced with a sumo wrestler on each side.  Right now we have sumo wrestlers. 

The economy is weak.  It actually had negative growth in the 4th quarter, and the second quarter was somewhat weaker than expected at 1.9%.  Much of that growth was due to a statistical mirage owing to an inflation measurement that was FAR below any other measure of inflation.  Nominal GDP growth was just 3.0%. 

Meanwhile, most measures of inflation are at the highest levels in decades and accelerating.  On a year-over-year basis, the producer price index [PPI] is up 9.1%, and it is rising at a 14.3% rate over the last three months.  The core price index [CPI] is up 5.0% over the last year and is running at a 10.3% rate over the last three months. 

Both fiscal and monetary policy are already gunning the engine fast.  The Fed Funds rate is already at 2.0%, well below most measures of inflation leading to negative real rates.  Traditionally, that leads to inflation accelerating down the road. 

While the dollar has stabilized in recent weeks, it is still at very low levels.  The weak dollar is a key reason why our net export situation, excluding oil, has improved significantly over recent months.  Better net exports has been the key driver for what growth we have. 

The other key driver is the economic stimulus checks, but the effect of those is about to wear off.  They have contributed to a projected Federal Budget deficit of over $400 billion for this year, and of over $500 billion for next year if one includes the costs of the wars in Iraq and Afghanistan. 

Despite all the stimulus, the economy is still very weak, particularly on the financial front.  The decline in the housing market is not over, and traditionally housing (and autos, which are also extremely weak) have led the U.S. economy out of recessions.  If the Fed were to raise the Fed Funds rate, it would be like a punch in the solar plexus to the financial system right now.  If they cut rates, the dollar would renew its decline and inflation would accelerate more.  These developments could lead longer term interest rates to spike higher. 

Thus the prudent thing to do is stand pat.  The next move the Fed makes is probably to raise rates, but I doubt it will be before December.  The policy statement may be mildly more hawkish, but don’t expect any actual moves.

We continue to recommend that people avoid the Financial stocks, especially those that are heavily exposed to the mortgage market.  Some of these include Fannie Mae (FNM - Snapshot Report) and Freddie Mac (FRE - Analyst Report), the private mortgage insurance firms like MGIC (MTG - Analyst Report) and PMI Group (PMI - Analyst Report). 

We continue to like the Energy sector.  The coal stocks like Peabody (BTU - Analyst Report), Arch Coal (ACI - Analyst Report) and Consol Energy (CNX - Analyst Report) have recently come down to very attractive levels and are very well positioned.

Read the full analyst report on FRE

Read the full analyst report on MTG

Read the full analyst report on PMI

Read the full analyst report on BTU

Read the full analyst report on ACI

Read the full analyst report on CNX