By Maurna Desmond
(Forbes) Investors and economists placed their bets Tuesday, some with investments and some with pens, on whether Federal Reserve Chairman Ben Bernanke will make good on his tough inflation talk and spike U.S. fed funds interest rates.
Late Monday, the Fed chief said that the likelihood of a significant American economic downturn had diminished substantially in recent months. He expressed concern, however, about inflationary pressures in the United States. His statements implied the Federal Reserve is more worried about stemming inflation, perhaps by raising interest rates, than stimulating a not-quite-so-weak economy.
While many on Wall Street jumped at the prospect of a rate hike, some aren't buying that the Fed will increase interest rates again. Morgan Stanley's Global head of interest rate strategy said Monday that he thinks it is "unlikely" the Fed will raise rates until mid-2009. He added that U.S. two-year treasury bonds are undervalued due to Fed interest rate hike fears. The economist added that he views the U.S. as "lingering below-trend growth" and not a prolonged recession according to tradethenews.com.
Treasury bonds were hit hard by the Fed chairman's statement, with interest rates apparently rising both because of the outlook that the Fed might begin to undo its easy-money policy of the past year and because of the inflation threat. The yield on the 10-year Treasury note, a benchmark for the world's capital markets, rose to 4.10% from 3.99% late Monday. As inflation rises, investors demand higher returns on bonds since the purchasing power of the money invested will be eroded. The 10-year yield ended the first quarter of this year at 3.43% as fears of financial collapse had investors running for the perceived safe haven of the U.S. government market.
The dollar benefited from the idea that the Fed might raise short-term rates. While the greenback gained to 107.20 yen from 106.30 late on Monday, the euro fell to $1.547 from $1.563 and the British pound slipped to $1.9548 from $1.9733.
Boston Fed President Eric Rosengren echoed Bernanke's concerns Monday saying that rising food and energy costs are impacting the economy from the top down, complicating the outlook for inflation. Dallas Fed President Richard Fisher warned that gradualism was still a watchword for the central bank, even though it had acted very aggressively in lowering interest rates to combat the fallout of the subprime mortgage crisis last year.
Not everyone believes that inflation is the greatest threat to the U.S. economy, but rather the burgeoning U.S. trade deficit which hit $60.9 billion in April, up from $56.5 billion in March. April's gap was substantially larger than the $59.5 billion economists had expected.
"The trade deficit heightens the risk of recession and surging unemployment," said Peter Morici, a professor at the University of Maryland School of Business and Forbes columnist. "Ben Bernanke’s recent comments about oil driven inflation only serve to distract attention from these issues and aggravate risks."
Morici argued that money spent on foreign oil, China's lopsided trade relationship that is propped up by a devalued yuan, and a few other key deficit components pose a growing threat to the financial health of the United States.