The Fed's Dilemma: Raising Rates Early Next Year

The Federal Reserve faces a big dilemma late this year and next year: How long can the Fed wait to raise rates and to cut back this liquidity injection? The Fed remains quite concerned about inflation; however, it has a more immediate priority -- to keep the financial system from seizing up.

Our economic slowdown is not having much impact on inflation. If anything, energy and food inflation may accelerate later this year. The PPI shows no sign of abatement. Core CPI declined recently, but headline CPI including energy and food remains high. If we're at the bottom of the cycle right now, and if this turns out to be a mild and shallow recession, the Fed will need to raise real rates back into positive territory more quickly than in past cycles. The Fed didn't start raising rates after the 2001 recession until June 30, 2004, two and a half years after the November, 2001 trough as announced by the National Bureau of Economic Research. I can't imagine the Fed waiting to raise rates until late 2010, or even late 2009. We would have to be in a much worse than expected recession for that to occur. The only question in my mind is whether the Fed acts preemptively once financial markets regain their footing late this year, or waits until next year after the election and after several quarters of growth have more fully restored confidence.

Looking at this in political terms, Washington never cheers a Fed rate increase, even if inflation is setting records. Congress always rails against tightening. The real issue for the markets is whether the next president backs the Fed. That doesn't mean the next president has to endorse rate hikes. He or she just has to refrain from criticizing the Fed and has to avoid openly dovish appointments to the Fed. The next president will enter office on January 20, 2009 with two vacancies to fill on the Fed's seven member Board of Governors. Eleven days later Randy Kroszner's term expires. A year later, on January 31, 2010, Ben Bernanke's term as Chair expires.

There is no doubt that the next president will put a big stamp on the Fed. Presidents like to control as many policy levers as they can. With regard to the Fed, the best presidents do that indirectly and out of public view. If John McCain (R-AZ) become our next president, even if he doesn't reappoint Mr. Bernanke, I don't see any market disappointment in his relations with the Fed. Although I wouldn't rule out the small possibility that Barack Obama (D-IL) or Hillary Clinton (D-NY) might play up to the markets as president -- they have banked a lot of campaign contributions from Wall Street -- it's much more likely that, when facing truly gigantic fiscal and foreign policy problems, they would make dovish appointments and play Wall Street as the villain that hurt Main Street.