Here's Why The Fed Still Can't End The Stimulus

The strong jobs report for March has expectations rising that the Fed will dial back its QE2 stimulus right away, and begin raising interest rates soon.

Even prior to the jobs report the president of the Minneapolis Federal Reserve Bank, and a voting member of the Fed’s rate-setting committee, said he expects a “big upward movement” in inflation, making it “certainly possible” that the Fed will raise interest rates this year. He said the so-called Taylor Rule, a method of predicting interest rates based on inflation, points to a sizable 0.75% increase in the Fed Funds rate if the rate of inflation he expects shows up.

And it’s true that inflation fears continue to circle the globe, and an increasing number of countries have reversed their previous stimulus efforts and are raising interest rates to combat the inflation.

It began a year ago in China, which had over-stimulated its economy the most, and was the first to see the danger signs, with potential real estate and stock market bubbles, and rising inflation. So more than a year ago it began tightening its previous easy money policies and raising interest rates.

Central banks in Brazil, Hong Kong, India, and a number of smaller emerging markets, became similarly concerned about inflation last fall, and have subsequently been tightening their monetary policies and raising rates.

The inflation concerns spread to Europe, and two weeks ago officials in Britain began preparing markets there for a hike in interest rates, which is now expected at the Bank of England’s rate-setting meeting next week.

Even in the U.S., the Federal Reserve reversed its previous ‘we see no signs of inflation’ outlook two weeks ago, saying “The recent increases in the prices of energy and other commodities are currently putting upward pressure on inflation.”

However, there was no indication of an early end to the Fed’s stimulus efforts, or a move toward raising interest rates to ward off inflation. Fed chairman Bernanke said that unemployment is a bigger concern than the threat of rising inflation, and the Fed would stick with its efforts to spur the economy, adding, “Until we see a sustained period of stronger job creation we cannot consider the economic recovery to be truly established.”

Ah, but now, with Friday’s very positive employment report for March, perhaps the Fed’s focus can turn away from jobs and focus on inflation.

After only 36,000 new jobs were created in January, 192,000 were created in February, and according to Friday’s report 216,000 in March. Meanwhile, the unemployment rate, which was 10.2% in October, and 9.4% in December, has continued to decline, down another tick at 8.8% in March.

So the new expectation is that now the Fed will begin preparing markets for an early end to its QE2 quantitative easing, scheduled to end in June anyway, and for the beginning of interest rate hikes.

It’s not likely to happen, and here’s why.

Reports over the last several weeks show quite clearly that the U.S. economic recovery began stumbling again, and quite significantly, in January, and it continued in February and March.

There were totally unexpected huge plunges in both existing and new home sales, permits for future construction starts, further declines in home prices, and big increases in the inventory of unsold homes, and pending foreclosures. Away from the depressing housing industry, the reports have been of unexpected big declines in durable goods orders, in consumer confidence, construction spending, as well as slowing manufacturing growth as measured by the Chicago area PMI Index, and the national ISM Manufacturing Index.

So, while the Fed was no doubt encouraged by the employment report, other concerns regarding the economy have probably replaced its worries about jobs, making it highly likely that the Fed will continue with its economic stimulus efforts, and keep interest rates low “for an extended period of time”, as it said after its March 11 FOMC meeting.

That probability could be seen in the action of gold on Friday after release of the very positive employment report.

Gold initially plunged a big $22 an ounce, apparently agreeing with the new expectation that the jobs report would allow the Fed to refocus its attention on the inflation threat, and begin raising interest rates. But on further thought, gold recovered, and closed basically unchanged for the week.

Meanwhile, the stock market reacted in typical fashion, since the monthly employment report usually causes a triple-digit one or two-day move by the Dow in one direction or the other. The other side of that pattern is that whatever is the direction of that move is usually reversed over the following few days, and the market goes back to focusing on whatever previously had its attention.

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