The Fed and the Economy – July/August 2006

On June 29 the Fed in order to ward off inflation raised the Fed Funds rate to 5.25% bringing up the overnight lending rate to its highest level since June 2004.and this was the 17th straight increase in the Fed Funds rate since that time.

In response to the softening in the inflation fighting language used by the Fed chair Mr.Bernanke in his July 19 testimony in the Senate banking Committee hearings the stock market celebrated the possible end in interest rate hikes via a 212-point rise in the Dow on July 20, 2006. The market enthusiasm was not sustainable and did not last more than a day in light of the fact that significant inflation risks remain because of high-energy prices. The onset of serious geopolitical events in Middle East in the last few weeks exacerbates the energy price risk further.

The minutes of the Federal Open Market Committee (the committee that decides on interest rate policy) meetings of June 19-20 reveals significant concerns about the recent rise in the core inflations rate (the CPI minus energy and food prices) which suggests that high energy prices are now getting broadly transmitted into the economy.

According to the U.S. Department of Labor the economy added 113,000 jobs in July 2006 down from the June increase of 124,000 jobs. The U.S. unemployment rate also increased in July to 4.8% from 4.6% in June. This is the highest-level of national unemployment we have had since February 2006 (July unemployment in California stood at 4.9%).

Another clear indication of a slowdown in the economy is that the second quarter 2006 real GDP growth was only 2.6% compared to the blistering pace of 5.6% in the first quarter.

The Department of Labor also reported that average hourly earnings rose for the month by 0.4% to $16.75 in July. This was comparable to the 0.5% wage increase in the month of June. Higher wages mean higher inflation unless the effect is offset by higher productivity.

In light of the June and July data we would say that the next move of the Fed is a toss up. The Fed will be tracking the core rate of inflation, job and wage growth, and productivity growth, as it makes a decision about the next move relating to the Fed Funds Rate in the August ‘06 meeting.

My hope, given the mixed messages from the recent data, is that the Fed will take a pause before it raises rates for the 18th time as current policy will have an impact on the economy for the next six and months and beyond.

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