President of the Minneapolis Fed and FOMC member Gary Ster said yesterday that the Federal Reserve shouldn’t wait for a bounce in housing and financial markets before raising interest rates. Stern cited concerns over inflation, which unexpectedly surged to 5% in June:
We’re pretty well-positioned for the downside risks we might encounter from here, I worry a little bit more about the prospects for inflation… We can’t wait until we clearly observe the financial markets at normal, the economy growing robustly, and so on and so forth, before we reverse course. Our actions will affect the economy in the future, not at the moment.
Stern is the longest serving member of the FOMC, and the only member who has served long enough to have worked with Paul Volcker. Stern’s comments, on top of the release of minutes from the FOMC’s June 24-25 meeting which revealed that some members favour increasing rates “very soon,” have pushed bond markets to assign a 79% probability of a rate hike by year end.
A rate hike, however, could all but destroy the momentum financial stocks have enjoyed since stronger than expected earnings from JP Morgan (JPM), Wells Fargo (WFC), and Citigroup (C) prompted one of the biggest rallies in the sector in recent memory. Citigroup CFO Gary Crittenden, for example, said in Citi’s conference call that Citi’s better results were “highly dependent” on lower rates.
Judging by Ben Bernanke’s language in his testimony to Congress this week, the FOMC has yet to settle on whether surging inflation or the ongoing mess in credit markets is the greater challenge to the economy. Either way, the FOMC will have to walk a fine line between hammering the financial markets and allowing inflation to wreak havoc on consumers.
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