Fed: The Federal Reserve left its target interest rate unchanged at 0-0.25 per cent on June 24. But it signalled that the US economy may be nearing a bottom. Its comments hinted that it may change its bias toward tightening sooner rather than later. If it wants to avoid a damaging run-up in commodity prices, it can’t wait too long.
It was no surprise that the Fed didn’t increase its target rate. The banking system and housing market are still fragile, and investor concerns over the amount of government borrowing on the horizon have been pushing up benchmark government interest rates.
But the Fed’s statement was notably less dire than it has been in the recent past. Gone was language about the threat of deflation, while the Fed nodded to improvements in financial markets and economic indicators.
Even so, by keeping its real overnight interest rate in negative territory, the Fed risks driving commodity prices up. Oil at around $70 a barrel is already double its February low. The deflationary effect on US purchasing power in today’s fragile economy of a repeat of last year’s oil market spike over $100 could cause long-term damage.
Even if the Fed repeats its mildly restrictive language after its August 12 meeting, markets in their summer lull may ignore the comments, while oil prices creep up. With investor risk appetite returning, speculative money could pour back into the oil market, and the Fed might have to resort to painful measures to halt an economically destructive price surge.
A modest monetary tightening would have probably caused a sharp but short drop in stock indices and in gold prices. But the risk of Fed inaction, and continuance of monetary expansion through its huge purchases of Federal housing agency and Treasury securities, is that it may have to abandon its incremental approach and move more rapidly toward tightening if another speculative bubble emerges. The central bank hasn’t taken away the punch bowl, but it should continue to signal that last call approaches.
