Experts Talk Discount-Rate Hike, CPI, Gold Prices

Bloomberg BusinessWeek compiles comments from Wall Street economists and strategists on the key economic and market topics of Feb. 19.

Drew Matus, Bank of America Merrill Lynch

The Federal Reserve announced [on Feb. 18] that, effective Feb. 19, it would raise the discount rate (the primary credit rate, in Fed-speak) by 25 basis points to 0.75%.In the accompanying press release, the Fed stressed that this action represented a "normalization" of its lending facilities and does "not signal any change in the outlook for the economy or for monetary policy." Despite this insistence that a larger spread of the primary credit rate over the interest-on-reserves (IOR) rate does not constitute a tightening of policy—and the fact that such a change was foreshadowed in both Chairman Bernanke's testimony on Feb. 10 and the FOMC minutes released this past Wednesday—markets reacted swiftly, with equity futures selling off and the dollar strengthening.

[T]he Fed seems to have separated policies designed to unfreeze the financial markets (namely, the various lending and credit facilities) from those aimed at supporting the economic recovery (namely, the "extended period" of an "exceptionally low" fed funds rate and the large-scale asset purchases). At the January meeting, the FOMC had announced that, on Feb. 1, it would close a number of the alphabet soup of facilities it created since the onset of the crisis, and it would let the swap agreements with foreign central banks expire. It also had announced that the last TAF auction would be on March 8. Raising the primary credit rate represents a final step in winding down this set of programs designed to provide emergency sources of liquidity. The Fed stated that one goal of this change is to "encourage depository institutions to rely on private funding markets for short-term credit," which should eventually restore the discount window to its original purpose as a "backup source of funds."

Importantly, as the Fed went to great pains to reiterate, this action does not signal that an increase in the funds rate target or the IOR rate is imminent. Indeed, the formal implementation of the Fed's exit strategy is still some time off, in our view—we continue to expect that the FOMC will not raise rates until early 2011.

Marc Chandler, Broth Brothers Harriman

The Federal Reserve announced it was lifting the discount rate to 75 basis points from 50 basis points. The timing has caught the market off guard, even though Fed Chairman Bernanke had hinted this was coming rather soon. However, even though the discount rate hike is a Federal Reserve Board decision, markets expected that the Fed would make such an announcement at an FOMC meeting. We had thought the meeting next month was mostly likely.

The decision to go between meetings is important. The Fed wants to drive home the message that it does not see this move as changing monetary conditions. That is to say that it is not tightening policy. This is properly understood as a incremental step toward normalization. There are many more steps to be taken before there is an increase in the Fed funds rate, or the rate paid on excess reserves. However, it is an important step, as incremental as it may be. In the current environment, it is unlikely to sway the market, which for the last three months has rekindled affection for the greenback that was so beaten up in the March-November 2009 period.

Joseph LaVorgna, Deutsche Bank

The January consumer price index rose 0.167% while the core registered its first decline (-0.136%) since December 1982, when it also fell -0.1%.Over the past 12 months, the headline CPI has risen 2.6% while the core has increased 1.6%. We expect the core rate eventually to bottom out at around 1.2% by the end of this year. The weakness in the core is predominantly due to housing: Owners' equivalent rent was down 0.1%, while rent of primary residence was flat. A 2.1% decline in lodging away from home (hotels, motels, etc.) was particularly soft. High housing vacancies will keep downward pressure on rents for some time. Apparel (-0.1%) and recreation (-0.1%) also declined. Education (+0.3%) and medical care (+0.5%) are two sectors that continue to show a trend of rising prices.

Since inflation is a lagging economic indicator, we are not particularly worried about the prospect of deflation. In our view, economic growth has turned the corner, and the production-based data are showing further traction in investment spending. The business side of the economy actually appears to be gaining some pricing power as evidenced in the wholesale sector: The rapid gain in core crude prices and the recovery in core intermediate prices are particularly noteworthy. The former is up 46%, while the latter is up 4%, from their respective cyclical lows. These price trends are noticeably firmer than where they were in 2003, so the Fed has to be careful to overstay its extreme monetary accommodation stance.

Stephen Briggs, Royal Bank of Scotland

The International Monetary Fund will "shortly" initiate the open market phase of its gold sales program. The gold market reacted very positively to the IMF's off-market sale of more than half of its planned 403 metric tons of gold to India (200 metric tons) and Mauritius (2 metric tons) in the fourth quarter of 2009. These off-market transactions reduced the potential tonnage that could be sold into the open market by the IMF, but they also prompted rumors of increased gold buying by Asian central banks, with China believed to be the most likely candidate. On-market disposals of the remaining 191 metric tons of IMF gold available for sale will be made in accordance with the "priority of avoiding disruption of the gold market" and may be accommodated under the 400 metric tons annual ceiling of the third central bank gold agreement. It is therefore unlikely that the sale of 191 metric tons of IMF gold would distort the physical gold market. That said, the market is likely to be pricing in the sale of at least some of the remaining IMF gold via off-market transactions, but more importantly, on-market gold sales would highlight the fact that any official sector bodies that might be looking to absorb gold are not willing to pay current prices.

The physiological effect of on-market IMF gold sales may help to put gold under pressure in the coming months. Other headwinds facing gold include: a stronger U.S. dollar, rate hikes in the U.S., the end of the gold gifting season, reduced inflows into the gold ETFs, and potential increased sales by European central banks … as fiscal positions deteriorate further.

We expect the gold price to decline from its current $1,100 per ounce to average $950 per ounce in the second and third quarters.

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