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Tuesday, August 01, 2006

Will The Fed risk a slowdown in the Economy to fight Inflation?

By Yaser Anwar, CSC of Equity Investment Advisors

Investors should keep in mind the Fed’s failed attempt to battle inflation in '94. By calling an end to the rate hiking cycle in August, that the rate hikes up to that point were “expected to be sufficient at least for a time to meet the objective of sustained non inflationary growth” only to realize how wrong this assessment was. And thus trying to play catch up, hiked rates 75 bp in November, leading to a rise of 100 bp in the 2-year yield within 3 months & nearly sending the economy into recession in '95.

The government's Personal Consumption Expenditures (PCE) Index, a measure of prices tied to consumer spending, rose at a 4.1% rate after a 2% rise in the 1st Q. The index excluding food and energy, a measure favored by Fed policy makers, rose at a 2.9% annual rate after a 2.1% rise the previous quarter.

The slowing economy & rising inflation makes one nostalgic of the economy in the '70s. It happened in the '70s & it happened in the last quarter. Bond traders sense a slowing economy, lowered rates across the board. The yield curve remains inverted. When the Fed raises rates, it will start to significantly invert. That means the statistical probability of a recession next year rises upto 40%+.

The recent monthly data from the Bureau of Labor Statistics confirms the rise in the PCE (Personal Consumer Expenditure). They peg inflation at 5.1% in the 2nd Q vs 4.3% in the 1st Q. They have inflation less food & energy for the last six months at 3.2% and all items at 4.7%. Since '06 energy prices have climbed about 20%, give or take.

Even though inflation data is backward looking, i don't believe the Fed will trust the slowing economy to handle future inflation problem. Investors should take into consideration that historically, the Fed has a tendancy to overshoot on its tightening campaign.

Currently, the sacrifice ratio (An economic ratio that measures the costs associated with slowing down economic output to change inflationary trends) is high. That means the dangers of rising inflation are such that the Fed could risk a slower economy rather than allow inflation to gain a mile. At 4%, inflation has gotton more than a mile. The sacrifice ratio, which Bernanke is a leading authority on, suggets that the Fed will raise rates in August.

Higher energy prices are having an effect on consumer spending. Not since the 1st 3 months of 1991 have home construction, consumer spending on durable goods, and corporate purchases of equipment and software all declined in the same quarter.

Lastly, answering the question i posed in the title, 'Will The Fed risk a slowdown in the Economy to fight Inflation?' I believe it should! 'cause with the economy finally slowing down, the Fed will have to step in & fend of inflation as they can't risk a situation like the '70s & '94.

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