Fed's Obsession with Inflation

[aquaswim47]

I'm going to take the opposite side of the transaction. I think that the market should be shorted on the basis that the FED will RAISE interest rates. I think people should buy consumer staples stocks; stocks like JNJ, UTX, CAT, MCD, BA, XOM/RDS-A/SUN,PG, PNRA, T, and GSK/TEVA. Everyone out there believes the FED will cut rates. Thus, if the FED does cut rates, that attrition (eating away at future returns with present returns) is already priced into the underlying stocks. But if the FED leaves rates alone or raises rates, expect the market to drop 5% with stable rates or 12.5% in the event of a rate rise.

However, mid-term (3-5 years), expect a robust stock market. I'm solely basing this short theory on the fact that everyone believes in a FED rate cut and I believe the FED's obsession on inflation will be overpowering.

I'm looking forward to your insight and comments. I believe the FED is disappointed about a 2% rise in inflation; a rate of inflation that no one else cares about.

[aquaswim47]

The FED won't cut rates; however, it should.

The fundamentals of companies are much stronger than they are at 2000. Yet, the Nasdaq is still trading below the level in 2000. Also, the S&P 500 index is trading at 15x earnings. If the market were trading at 18x earnings, the Dow would likely be trading at around 14,000, instead of 12,500. A Fed rate cut would allow the market to reflect its true valuation.

I think inflation should be between 3-4%, not under 2%. The Canadian bank has 4.5% interest rate, Britain has a 5.25% interest rate, and Europe is at 3.75%.

[WallStGolfer31]

If you think inflation should be around 3%-4%, but is currently at 2%, why would the fed raise rates? That would lower inflation. If you want 3-4% inflation, you'll have to cut rates. Can you explain the logic behind your theory?

[aquaswim47]

Good point. But I think you read through my messages too fast and misunderstood that the second message had a different subject matter from the first. The FED wants to lower inflation; by no means, do they want an inflation rate of 3-4%. At least that is what I get out of the FED every time Ben opens his mouth (which is not that often). They have an ideal of inflation being under 2%. Maybe, the FED has a legitimate reason to not lower interest rates; an acceleration of inflation might increase the borrowing costs of the government in TIPS, but especially for those who hold I-Bonds (as those who hold I-Bonds receive twice the rate of inflation + a 1-1.2% fixed interest rate). TIPS usually receives the inflation rate + 2.5% (so TIPS do not increase borrowing costs as they would be matched by the rate of inflation).

I had two messages: the Fed's decision and the reason why we should cut rates.

If inflation is hovering even slightly over 2%, lets say 2.2%-2.25%, the FED will raise interest rates because they want inflation of 2% in the market and anything above it, is unacceptable (the reason for the word, obsession). If it is near 2%, the FED might keep rates alone. I don't think the FED would cut rates unless inflation reached 1-1.5%. The market may cut rates if it believes that the economy needs stimulation. For example, the market Federal Funds rate is at 5.22% (three basis points below the FED).

With these low tax rates (the lowest since the early 1930's), the unemployment rate should be 3-3.5% like they are in NH and that would only happen with a 3-4% inflation rate.

The second message stated that rates should be cut so we have a more realistic inflation rate of 3-4%.I think the FED has misplaced priorities and that is why they're going to raise rates; the FED thinks the market is overheated at an inflation rate that is below 2.25%. I don't think you can perfect the employment/inflation line and that the concessions of a rate decrease by .25% to .5% would raise inflation to 3-4% and further improve the economy. A 3-3.5% unemployment rate would be a robust economy; that's an ideal that this FED may not achieve on its own. Other factors will have to be in play that will cause a robust economy (such as a biotech boom). The 4.5% unemployment rate, albeit low, is what I would call an average unemployment rate given the fiscal policy we have in play.

By the way, I'm interested in verifying the accuracy of the Canadian, British (UK), and European interest rates. That would be very helpful as a baseline to see how we compare with the world economy. I also own some I-Bonds, so an inflation rate of 4% would result in a 9% interest rate on my $590 worth of bonds and off course, I would buy more I-Bonds for my emergency fund portfolio.

[WallStGolfer31]

You do know the fed has many other tools to adjust inflation, like money supply. I read what your saying right, I was just trying to respond previously to what you're implying, not to what you're saying.


I mean this in the least offensive way possible, but I'm not sure you completely understand how monetary policy works. Check out some more background information concerning the Philips curve, review the AS-AD/IS-LM models, the natural rate, and the conditions concerning both short and medium run equilibrium. These in combination should clear things up.

[aquaswim47]

Yes, the natural rate of unemployment is around 6%. Also Keynesian economics stipulates that there is a tradeoff between employment and inflation. Good advice though. I acknowledge that the Fed Funds rate is attributed to the FED either tightening the money supply or having a more leinent monetary policy; in other words, if the FED lowered the Fed Funds rate to 5.00%, it would buyback Treasuries from the marketplace thereby increasing the money supply. If it increased it to 5.5%, it would issue bonds to the public (thus tightening the market).

I believe we'll be at the peak of the business cycle by 2012 due to a biotech boom.

[WallStGolfer31]

Well it's actualty it was Philips that first defined the relationship between unemployment and inflation. Like I said before through, review those models, and some things should become clear.